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Economics ResearchEconomics Products: Absolute Strategy Weekly, Economics Quarterly, Newsflow Monitor.
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Equity Strategy: Uncertainty and a rising ERP = Underweight UK
Multi-Asset: Unwinding of the reflation trades; equities at risk
Economics: Can Germany and France script a blockbuster?
What Happens Next – the Constitutional Timeline
If the Conservatives are unable to come to an arrangement to work with the Democratic Unionist Party (DUP), the Labour will be given the chance to form a government. If they cannot, the UK could face another election within two months.
At the time of going to press, it looks like the Conservatives will try and form a government with the DUP. But the election has made Mrs May more, rather than less, of a hostage to the eurosceptic wing of her party. If a partnership with DUP compromises the latter’s vision of Brexit too much, some eurosceptics may prefer early elections (with a new Conservative leader), than see Brexit compromised.
Who are the DUP and What Brexit will they Want
The Democartic Unionist Party (DUP) is the largest unionist political party in Northern Ireland, and won 10 seats in the election. The conservative DUP could provide the Tories with a working majority of 16 seats. But this support will come at a price and could have a major impact on UK’s Brexit priorities.
Implications for Brexit Outcomes
Going into this election, we believed that the most likely outcome was a ‘hard’ Brexit with the UK forced to trade under WTO rules. We thought it was unlikely there would be a transitional arrangement because of the Conservatives two red lines: and end to free movement and an end to ECJ jurisdiction. An arrangement with DUP could change the dynamics.
Implications for Sterling and Gilts
Sterling was already our least favourite major currency on a 1-2 year view – we had said we would not be surprised to see EUR/GBP move to parity before the Brexit negotiations were completed. The UK election result reinforces our negative view.
Gilts will be supported by the UK’s weak growth prospects. But a political risk premium may start to appear in Gilts’ relative performance if central bank reserve managers start to get cold feet. Moreover, if the Conservatives fail to form a stable government, the rating agencies may review the UK’s sovereign rating – especially if this election result marks a rejection of further austerity and and end to fiscal retrenchment. Throw in a Brexit-related slowdown and UK public finances could start to become a major problem.
Implications for UK Equities
This election result does nothing to improve the UK economic prospects and much to increase uncertainty and boost the UK’s ERP. In terms of sectors, this should weigh on domestics - Retail, Banks and Travel & Leisure are vulnerable - and Small Caps. Internationally-focused Equities are likely to benefit from the pullback in GBP via the boost to earnings, although we do not expect this to be a ‘get out of gaol free’ card for UK Equities to the same extent at last year. We re-iterate our Underweight recommendation for UK Equities in a global portfolio. It remains exposed to the cycle with its high weights in Finanacials and Resources a concern.
• The ASR/WSJ Global Composite Newsflow Indicator (CNI) of macro activity fell in May to stand at 57.0, compared with a 59.1 reading in April. Global CNI readings of around 50 have tended to be associated with stock returns keeping pace with bond returns on a year-on-year basis (see Chart 1). The Global CNI fell for the second consecutive month – it is now back to pre-US election levels. This move is historically consistent with a fall in the equity-bond returns ratio.
• Our proprietary NewsFlow indicators are created by searching the Dow Jones Factiva database for ‘positive’ and ‘negative’ macroeconomic news stories, counting them, and then calculating the difference (the ‘net’ news flow). The searches are done in English, so the global series will be dominated by stories from and about the Anglo sphere. But they still capture global trends well.
• The Global CNI is built up from six sub-indices – see Charts 2-7 on pages 2 & 3. The inflation sub-indices fallen 37-points since the start of the year, consistent with the fall in the input prices PMI (Chart 6). But the picture was relatively consistent across each sector. Only the Economics NewsFlow rose on the month.
• On a regional level, only Australia was insulated from the fall in media sentiment. The US fell the most – like the Global measure, it experienced its second +1 standard deviation fall in as many months (Chart 8). Of particular concern was the US labour market measure which had held up relatively well (Chart 15).
• Our Stimulus NewsFlow suggests that disappointed expectations around policy may have played a role in the reflationary story dissipating (Chart 50).
Please see below for full contents
Equity Strategy: Hedge Macro environment with long Quality, short Low Vol
Factor investors need to be aware that the timing of their returns is dependent on the macro environment. The last 20 years shows Quality and Low Price Volatility factors are sensitive to changing economic activity, yields and inflation expectations, and a long Quality short Min Vol strategy eliminates most macro risk. In contrast, Growth and Value have had persistent but unstable relationships with economic activity, while trend Momentum is largely uncorrelated with macro indicators.
Multi-Asset: AUD inflation protection looking cheap
Australian 3-year bond yields are down some 50bps from the mid-March peak. This looks at odds with some recent inflation data in Australia. We recommend buying AUD 5-year inflation protection. This is now our preferred way of positioning for upside surprises in Australian nominal GDP growth; we recommend clients take profit on the long AUDUSD / short Copper trade idea from January.
Economics: An Ocean Apart: EU27 and UK
Rather than taking a pragmatic approach to the upcoming Brexit negotiations, the EU27’s priority is to limit political contagion in its remaining member states, while insisting that the future relationship is consistent with the EU’s rules. We believe the UK could be presented with a ‘capitulate or cut-off’ dilemma which, given ASR’s analysis of the UK’s position, increases the chances of a ‘hard’ Brexit.
PODCAST:Click to hear Michael’s accompanying podcast
• Hedge Macro environment with long Quality, short Low Vol, by Charles
• Break-evens ignore rising AUD CPI-inflation, by Chris & Stefano
• Sentiment extremes and markets on the move, by David
• How Europe views Brexit, by Michael
• Absolute Release: ASR leading indicators, by Ben
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