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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.
ASR’s CIO Pack summarises the macro and the market environment. In addition it highlights 10 charts from the ASR research team for the month. For June these include:
• Equities gained as an Inventory Shortage boosted Activity
• The I-S Ratio, Prices Paid and US Break-Evens
• ASR Composite Earnings Indicator and Top-Down Models
• Sector Risk Appetite has Waned Relative to Stocks/Bonds
• Eurozone Banks Relative and the German Yield Curve
• Sensitivity of main equity factors to economic activity
• AUD inflation break-evens look cheap
• Dashed Hopes for US Tax Reform
• US corporate debt: a growing concern
• UK Election reinforces negative view on Gilts and Sterling
Overview: Global Equities set for a 5%-10% correction in H2
The rally in Global Equities, which has delivered gains of 13% since January 1st, looks set to be challenged in H2.
Economic growth is expected to moderate, limiting earnings growth to around 5% y/y, exposing valuations that are now extended.
With liquidity also ‘as good as it gets’ and sentiment looking excessively positive, Global equity returns will likely moderate.
The risk reversal evident in our Reflation Trade Diffusion Indicator is consistent with an equity reversal of 5%-10% in H2.
Equity Strategy Investment Conclusions:
• Reduce risk in Equity portfolios – ‘sell the rallies’ rather than ‘buy the dips’
• Look for US Equities to beat Eurozone & Asia-ex-Japan in a falling market
• Consumer Staples & Pharma will be more resilient than Industrial Cyclicals
• Expensive Tech will continue to beat cheap Financials until the cycle revives
• As activity slows Growth-based factor investing will beat Value-based styles
Article 1: Shifts in ROE are Key to Regional Re-Rating
Eurozone Equities have underperformed US Equities for a decade, largely due to their lower profitability (ROEs of 10.5% vs 16%).
We show how investors typically wait to see sustained shifts in ROEs before embracing major regional rotations.
Article 2: Time to downgrade Global Industrials
Industrial stocks have performed well as Global growth has recovered. They will suffer if growth slows and pricing power moderates in H2.
However, we expect Engineering and Electronics to suffer more than Aerospace.
Equity Strategies for Three Macro Scenarios
Equities appear to be priced for a scenario of upside growth surprises. A scenario of even stronger growth with moderate inflation should boost Europe and Asia.
A darker scenario of slow growth met by protectionism leaves few places to hide
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