Investment Outlook – Tom Elliott – A fortnightly look at global financial markets

  • Trump’s illness- more unwelcome uncertainty to the U.S presidential election
  • Brexit no-deal haunts U.K stocks and the pound
  • The unloved U.K stock market might offer good value
  • Meanwhile, investors currently favour U.S tech and Chinese stocks and bonds
  • Investors should remain diversified

Market sentiment: Unsettled. We are seeing an increase in volatility on risk assets, as fresh outbreaks of Covid-19 lead to a re-imposition of restriction of movement in many countries. Investors are bracing themselves for a delay in the global economic recovery, as a result. While this is good news for the ‘work from home’ tech-based stocks that have dominated the U.S stock market’s rally since late March, it has curtailed the recovery that we were seeing over the summer in a broader swathe of cyclically-sensitive stocks, such as industrials, in the eurozone and Japan.

In addition, political uncertainty is at a high level. In the U.S, President Trump’s refusal to commit to the November election result has already led to a flurry of market analysts notes along the lines of ‘worries over the future of American democracy’. His, and his wife’s, contraction of Covid-19 adds to the uncertainty of what was already becoming a fraught election. Last week’s trade talks between the U.K and E.U failed to achieve a breakthrough and appear to likely to drag on until the last moment possible in December, putting further pressure on investor confidence and sterling. In Japan, long-term Prime Minister Abe has announced he will be stepping down for health reasons – will his successor accelerate economic reform or put it on hold?

The VIX index of implied volatility on the S&P 500, the so-called ‘fear index’, has jumped back up to 29, a level last seen a month ago when the NASDAQ began what turned out to be 10% correction.

The unloved U.K stock market …an opportunity? Is there an argument to be made for the unloved U.K stock market? So unloved that, in a widely reported anecdote, Apple was briefly last month worth more than the entire FTSE 100 index of leading U.K stocks.

The broader MSCI U.K index of large, mid and small-cap stocks is down 21% this year, as investors shun the banks, energy companies, travel, leisure and miners that dominate the U.K stock market for Covid-19 related reasons. The U.K lacks large quoted tech companies, of the sort that have led the recovery on the S&P 500. Dividends have been cut in traditionally reliable payers, with some companies talking of re-setting pay-outs at new, lower levels when the crisis passes.

In addition, leaving the E.U’s single market and customs union in January will put further strains on the domestic economy – the extent of the damage will depend on whether an agreed deal based on a Canada-style ‘hard Brexit’ is reached in time, or is not. The political union between England and Scotland, and possibly also that with Northern Ireland, may be undone as a consequence of Brexit. Indeed, the apparent casualness with which the government appears to value the union astonishes other countries.

Demonstrating its unloved status, JP Morgan Asset Management calculates that the broad U.K stock market is amongst the cheapest in the developed world, on a forward p/e of around 15 (compared to 22 for the U.S)*.

And yet…the same study by JP Morgan shows that corporate earnings growth has considerable potential to bounce back when normal economic life does resume, and people once again travel and socialise, and companies resume stalled investment plans. Perhaps not as much as in other regions of the world, given structural headwinds facing oil stocks, and financial stocks too if interest rates remain at current low levels. But sufficient to trigger a re-rating of p/e valuations. If so, the U.K main market may currently offer tremendous value opportunity.

It is worth remembering that all those who successfully follow the adage ‘buy low, sell high’ have by definition ignored the fashion of the time.

Who’s the fairest of them all? But if global investors are currently turning their back on the U.K, where are they looking for opportunities? Two themes currently stand out: U.S tech remains popular, while Chinese stocks and bonds are getting more interest from global investors.

U.S tech. Valuations are high by historic standards. But, the argument goes, so is the sector’s projected earnings growth. And in stark contrast to the dot.com bubble of the late 1990s, many of the leading tech-related companies are sitting on a great deal of cash with which to fund future growth. Some sit on effective monopolies, while few sector analysts believe that any anti-trust legal action, which might come from Congress, will lead to the break-up of any of them.

China. The second theme, particularly popular with investors in emerging markets, is Chinese stocks and bonds. In contrast to many other large developed or emerging economies, investors see in China a resilient economy, stable government, and -in common with many other east Asian countries – relatively successful handling of the COVID pandemic.

There remains a lot of potential for ‘catch-up’ of household income levels in the central and western regions, to the levels enjoyed in coastal cities. Trade disputes with the U.S, the argument goes, will galvanise the domestic tech sector to become independent of western suppliers, for example developing their own world-class microchips. Remarkably, China reported second-quarter GDP to be 3.2% higher than the same period last year. (This contrasts with falls of 21% in the U.K, 9% in the U.S, 10% in Japan and 15% for the eurozone over the same period). The MSCI China stock market index is up almost a fifth year to date.

There has also been a marked rise in buying by foreigners of Chinese on-shore renminbi-denominated bonds, issued by both the government and by so-called ‘policy banks’ (these are state-controlled institutions such as the China Development Bank, that direct government funds into favoured areas of the economy). They offer higher yields than those of major western countries, with a relatively low correlation with other global bond markets. There is also the opportunity for currency appreciation, as the Chinese authorities attempt to make the renminbi a major reserve currency (though this long term project is surely stymied by capital controls).

Remain diversified. Successful long-term investors maintain a diversified portfolio of stocks, bonds and other assets in order to limit risk. Given the number of uncertainties that investors are currently grappling with, this approach is worth emulating. Volatility on the financial markets looks set to rise as the U.S November elections approach, against a background of potentially more restrictions on movement that will delay economic recovery and on news of potential vaccine treatments.

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