Portfolio Adviser • October 2016 • Contrarian

Consensus suggests it is a struggle to find value in equities, but despite political uncertainty in the UK, US and Europe, there are still plenty of opportunities globally

Key economic indicators are forecasting a very low risk of recession in the coming months; 1987 aside, bear markets do not occur without one. Global indicators have risen, and our measure suggests global growth will end 2016 at about 3% in real dollar terms, around the 30-year average.

There are three key risks to the equity markets: a clean sweep by Republicans or Democrats in the US presidential election could herald an era of protectionism; the Italian referendum and banking bailout could spark renewed political uncertainty in Europe; and Brexit may cause a greater slowdown than anticipated.

That said, equity risk premiums offer investors considerable compensation in the UK and the US, but not enough in the eurozone.

Prior to the EU referendum in the UK, our analysis suggested a Brexit vote would shake confidence and the shock would slow growth to as good as zero, but that a recession was not guaranteed. Post-referendum, we upgraded our outlook for domestically focused equities, as many stocks were pricing for a far higher probability of recession than was suggested by our analysis.

After some immediate jitters in the UK economy, indicators do not suggest a recession is on the horizon. Consumer confidence and purchasing managers’ index (PMI) surveys even suggest mild growth.

Within the FTSE 100, those stocks that are most exposed to the UK are yet to recover but the more domestically geared FTSE 250 has rebounded strongly, though valuations remain depressed, especially relative to large caps. Looking at valuations relative to global equities, the FTSE 250 still provides a large cushion against macroeconomic shocks.

The performance of the FTSE 100 relative to global equities seems consistent with in the price of oil and better Asian macroeconomics. However, the first of these is unlikely to offer a tailwind from here on. At this juncture, volatility is unlikely to resume until the UK parliament triggers Article 50.

In the US, over the next few months we anticipate an increase in political uncertainty that has the potential to dampen valuations, temporarily at least. Although our analysis tells us valuations have been higher on average 15% of the time during the past 20 years, US valuations are notably higher than in other regions.

That said, the equity risk premium does seem to be factoring in elevated uncertainty. The market-implied equity risk premium on the S&P 500 came close to reaching financial crisis levels in February. It remains near a two-year high today, and even a slight retracement would realise considerable upside in stock prices.

A Trump or Clinton clean sweep, of the Executive, House and Senate, could herald a protectionist turn for US trade policy that would lower long-run expected returns on US equities due to a weaker outlook for productivity growth, which is the driving force behind any developed economy. Long-term asset allocators should take note.

Pre-empting what tariffs will be applied to which goods is a hugely speculative task, so we prefer to analyse the scenario via a ‘shock’ increase in economic uncertainty. After all, a drastic change of trade policy would cause uncertainty over all facets of the trade process. A regime change would likely result in the postponement of expansion plans as well as general belt tightening.

Our analysis suggests that a one standard deviation shock increase in uncertainty renders US GDP between 1-2% lower after two years, relative to what it would have otherwise been; the impact could be worse still given the limited scope for monetary policy.

The spectre of the election aside, the macro environment continues to appear robust, although Q3 GDP may present a peak.

In Europe, the macro picture remains robust. Monetary indicators are all positive: lending to the private sector rose to 1.7% year on year in July, which is the highest rate of growth since 2011. Loan maturity is also increasing, which, coupled with survey evidence, may suggest that this borrowing will be used for investment rather than for financial engineering.

Labour market and consumer indicators are also strong, relative to the past five years, and have remained so since their dramatic recovery in Q4 2015. Consumption growth has recovered to pre-crisis levels. So why are we underweight?

Current valuations do not offer enough compensation for the elevated risks to earnings growth. When one discards the cheapest and richest sectors, eurozone equities are more expensive than the FTSE and not far behind the US. Similarly, the equity risk premium, while elevated, is not as far above its long-run average as in the UK or the US.

A loss for Italian prime minister Matteo Renzi in the constitutional referendum in November could throw Italy into an existential crisis, delay the essential restructuring of its banking sector and place Italy at loggerheads with the eurozone establishment.

If the Italian leadership loses the support of the eurozone institutions, the entire region could suffer a loss of confidence. And investors should be only too aware how episodes of acute equity market stress in Europe have coincided with political events during the past few years.

Turning to Japan, we believe the four key secular drivers behind Japan’s outperformance are still intact:

. A radical improvement in return on equity due to improved corporate governance.

. An increasing shareholder focus will lead to return of cash mountain by way of dividends and buybacks.

. A huge potential for multiple re-rating as pension funds (and now the Bank of Japan) allocate to equities.

. Potential for multiple re-rating as positive inflation expectations and a hunt for yield leads households into equity ownership.

Even as stock prices struggled this year, operating margins came back strongly in Q2, while buyback announcements continue to smash last year’s record-breaking highs.

Yet we cannot escape the fact that the macro environment continues to deteriorate, eroding market sentiment. Japanese earnings breadth and the momentum of analysts’ revisions were stronger than any other major market over the past two years but this has fallen into negative territory.

Headline inflation has fallen sharply to -0.5%. Although core inflation is still at +0.8% and the highly regarded Hitotsubashi CPI has plunged from +1% at the start of the year to -0.3%. Worse, inflation expectations have fallen to a four-year low.

Although they remain positive, which for Japan is still quite something, it is concerning, given that smashing the deflationary mindset once and for all is essential if president Shinzo Abe and Bank of Japan governor Haruhiko Kuroda are to succeed in reigniting the country’s new economy. We remain positive on the market, with a modicum of caution.

In Asia and emerging markets, data for July suggest the growth of developing economies’ GDP is set to improve in Q3, after six years of near continuous deceleration. Almost all emerging market PMIs are back at more than 50. Although one quarter does not make a trend, it is important to take note.

The turning points in the performance of both emerging market debt and equities relative to their developed market counterparts coincide with turning points in GDP differentials. In other words, when the gap between emerging and developing market GDP growth starts to widen, emerging market assets start to outperform.

The gap may be about to widen due to the easing of severe recessions in Brazil and Russia, while other commodity exporters, such as Indonesia, are also turning a corner. In particular, the recovery in consumer spending has gathered momentum since spending troughed in Q4 last year, led by healthy gains from non-commodity economy sales but also supported by the commodity economies.

Falling inflation in Asia has given policymakers renewed scope to adopt more accommodative monetary policy.

Importantly our ‘nowcast’ of Chinese GDP – an attempt to measure the true rate of growth that likely belies the official numbers – seems to have reached a firm floor this year. We prefer emerging Asia to Latin America. Latin American equities have rallied sharply, but earnings momentum remains poor and the politics is unhelpful.

‘A TRUMP OR CLINTON CLEAN SWEEP, OF THE EXECUTIVE, HOUSE AND SENATE, COULD HERALD A PROTECTIONIST TURN FOR US TRADE POLICY’

‘OUR ‘NOWCAST’ OF CHINESE GDP – AN ATTEMPT TO MEASURE THE TRUE RATE OF GROWTH – SEEMS TO HAVE REACHED A FIRM FLOOR THIS YEAR’

. Equity risk premiums still offer investors considerable compensation in the UK and the US, but not enough in the eurozone.

. Valuations relative to global equities suggest the FTSE 250 still provides a large cushion against a macroeconomic shock.

. Either a Trump or a Clinton clean sweep could herald a protectionist turn for US trade policy.