Market exuberance or dawn of a post fiscal austerity era?

22 July 2016

Stock markets reached new highs for the year over the past week and our investment portfolio returns for 2016 have moved up from lower single digit returns to upper single digit and in some cases even double digit returns.

So, were all those doomsday scenarios that were foreseen in case of a Brexit vote, simply '˜Project Fear' after all? Well, the expected capital market shock clearly did not extend beyond the 2 days in the immediate aftermath of the referendum. The first economic data flow since the Brexit for the UK vote this week, however, has been very much in line with gloomy pre-Referendum projections. Friday's release of the preliminary purchasing manager index for the UK (PMI - forward looking indicator of business activity) revealed the sharpest one month fall since the index's introduction 20 years ago and more worryingly, that the UK economy has entered a period of contraction after previously expanding until the end of June.

The UK stock markets dipped only briefly on this, before recovering and closing higher.

Much of this week's Tatton Weekly revolves around this paradox and the different explanations given. Fact is that reputable economists expect economic decline for the UK - at least over the shorter term - while markets seemingly ignore that UK companies may become less profitable over the next reporting periods.

There are 3 main explanations we have discussed and observe being debated elsewhere:

  1. The near 10% devaluation of £-Sterling will provide export stimulus, make overseas earnings 10% more valuable and attract Global bargain hunters of UK corporate assets which are also now 10% cheaper. All this combined will equalise the drop in domestic activity the economists forecast.
  2. The absence of the predicted global financial market turmoil has made markets more confident that Global growth will persist and neutralise any adverse Brexit related slowing. Furthermore, overseas investors may believe that the Brexit won't really be a Brexit - some compromise may be found in time. Just as markets were wrongly over-pessimistic at the beginning of the year, there is a risk that they are wrongly over-optimistic now.
  3. The Brexit vote has shocked the political class world-wide to the point where they will have to step up their efforts to accelerate growth or be disposed onto the scrapheap of political history. Fiscal austerity therefore makes way for fiscal expansion, which, just like the 1933 US New Deal, finally leads to a return of decent growth rates. In the meantime, monetary policy will be forced to keep rates at ultra-low levels which makes equities more attractive as long as there is no serious recession ahead.

Given the dire economic outlook for the UK, we have for a while now discussed to take profits in some of our UK investments and position portfolios for an equity underweight until it becomes clearer where the UK is heading in their relationship with the EU. Market momentum has persuaded us to hold fire, following the old market adage - '˜Don't fight the Fed' (Markets being the Fed in this case). This has been the right decision for portfolio returns - for now.

However, we remain on edge regarding further developments, both in terms of market action, but also political action and economic developments.

Markets proved their resilience this past week by continuing to climb despite the Nice terrorist tragedy, heightened political instability at Europe's neighbour and ally Turkey and last but not least, as already mentioned, confirmation that UK business activity has indeed slowed very severely since the Brexit vote. On the political side, the increasing talk of fiscal stimulus to counter political radicalism is encouraging (more below) and the fact that the Article 50 trigger of Brexit negotiations is now most likely not to occur before 2017 are all supportive from a market sentiment perspective.

On the economic side then, much will depend on whether the initial drop in activity will persist, or proves short lived, just as the market upset quickly reversed. At least on the Global level, fairly strong economic data flow and good company earnings reports, would suggest that once again the Global economy is far more resilient to short term shocks than we give it credit for.

So in summary, for the time being, we are most relieved that we did not get yet another market shock reaction as in January and that this relative market calm versus the anxiety of politicians to finally address the slow-growth malaise of the past years may actually turn the outlook less negative than imagined possible just a few weeks ago.