UK business sentiment rebound

5 September 2016

Both the week and the month closed on a strong note for investors. Our asset class returns table for August shows that all asset classes generated healthy contributions to portfolio return, with the exception of the 0% flat-lining of property and cash.

The month of August was characterised by a continuation of the healthy pickup in economic activity around the world – with the exception of Britain, which had to digest reports of a massive slowdown in activity levels during July. UK stocks and bonds went up regardless, partially due to further falls in bond yields (which cause bond values to rise) and the weakening of £-Sterling and last but not least to some extent because market participants appeared to apply the principle of the ‘benefit of the doubt’ to the post Brexit decision economic environment. Political chaos had been overcome and actual Brexit consequences seemed to have disappeared over the horizon of drawn out, longwinded divorce proceeding, during which much could still change.

Over the past week the dynamics have begun to change slightly. Firstly, comments by representatives of the US central bank, the Fed, seemed to suggest that the next rate rise there may come earlier than anticipated – i.e. September rather than December. This sent equity markets for the first time this summer properly into reverse, because they continue to fret – as they have for the past 18 months - that the Fed may be moving too fast. The resultant US$ strength would be bad for the Global economy in general and the developing world’s economies in particular (we reported and explained in past editions).

Secondly, initial data releases for August for the UK showed that business activity levels recovered somewhat, rather than plummeting further. This was much as we had expected and hoped, but nevertheless surprised markets positively. After ‘not so bad’ manufacturing and construction sentiment reports, both UK stocks and more importantly £-Sterling rallied. For investors this proves a double edged sword, because the resulting, over 2% currency depreciation inflicted on overseas investments easily erased the market gains there. I feel some pity for fellow investment managers who followed the textbooks’ wisdom and reduced their UK investments in anticipation of a continued UK slump.

Global stock markets turned as well and also rallied into the weekend, however, this was not UK driven but rather the result of US labour market data for August which showed that job and wage growth is not quite strong enough to force the Fed’s hand towards a September rate rise after all.

While the data flow informs us that we remain in a supportive environment for investment returns, the up and down of the week also indicates that market participants remain on edge and don’t quite trust the resilience of the new valuation heights we have reached over the summer. Recent reports suggest furthermore that there is an increasing divide in sentiment between institutional investors (pension funds and investment managers like Tatton) who focus on the long term fundamentals of the economy and the ‘fast money’ on the other side, with retail investors, hedge funds and other short term punters, who focus more on a multitude of market ratio comparisons with historic observations. While institutional investors are increasingly looking forward positively because of accelerating economic activity levels, the retail and ‘fast money’ investors just can’t get their head around many distorted looking market metrics, which have been skewed away from historic averages because of the extraordinarily low cost of capital (interest rates and bond yields).

This creates an uncomfortable environment of jittery market action, where direction is veering from being driven by macro-economic fundamentals to short sharp sell-offs, caused by highly nervous marginal investors overreacting to sometimes erratic economic data.

As long term investors, driven by fundamentals, we are looking more optimistically into the medium term future and will most likely use sell-offs to increase equity exposure at the expense fixed interest bond allocation, which now offer very little further upside for the foreseeable future.

To this end we noted over the past weeks, that the economic surprise surge we had experienced for the past 3 months has begun to top out. That is not overly surprising or worrisome – after the acceleration, a certain ‘cruising’ level has been reached. However, the decline of positive surprise events will rob markets of their fuel for upward dynamic and make them more vulnerable to negative data surprises, which occur even at the best of times.

This, combined with the return of politicians from their summer break, is likely to mean that the pleasant summer calm is ending. Debate over the best route towards the eventual split from the EU, together with the heating up of the 2016 US presidential campaign, almost guarantees to provide more events to spur market volatility over the coming weeks. September tends to be a difficult period for stock markets, but so is the period between May and September, which leads me to conclude, that while the probability of market volatility and sell-off periods has increased, it is by no means a certainty.

To finish on a positive note, the first UK property fund that had been suspended from redemptions in the aftermath of the post-Brexit property fund sell-off, re-opened last week. This is a good early sign that in the commercial property sector, just like in the rest of the UK economy, things are returning towards an, at least temporarily, calmer normal.