Market Outlook Report – July 2017

Overview

The UK economy is stumbling and is unlikely to have gained any momentum since its disappointing start to the year, as indicated in a trio of poor figures were released that also cast doubt over a potential rise in interest rates this year. Output by British factories fell, the construction sector shrank unexpectedly and the trade deficit widened in May, according to official figures. The pound fell to a nine-day low against the US dollar after the news emerged. “It’s all building up a pattern here that says the economy is clearly losing momentum,” Peter Dixon, economist at Commerzbank, said.

Construction output in the United Kingdom declined 0.3 percent year-on-year in May of 2017, following a downwardly revised 0.1 percent fall in April and compared to market expectations of a 1.1 percent gain.

Analysts had been optimistic that the economy would rebound in the second quarter, after expanding by only 0.2 per cent in the first three months of this year, which was the slowest growth of any nation in the European Union. However, the latest disappointing figures have caused a number of them to cut their growth rate estimates from 0.4 per cent to 0.3 per cent. “This has added a further dose of pessimism to our assessment of the UK’s economy’s performance through the second quarter,” Victoria Clarke, an economist at Investec, said.

So, as markets gear down the summer lull, fund managers have been giving their views on the UK economy and in the likely impact on the British equities. Anthony Rayner, manager of Miton Asset Management’s multi-asset fund, described Britain as an “empire already declined and struggling to find its way post-Brexit”. He said he had “minimal exposure to the UK”. Also taking a gloomy view on domestic equities yesterday was Brooks Macdonald. In the fund manager’s latest quarterly asset allocation review, it singled out UK stocks as ones to avoid, saying it would cut its holdings. “Political uncertainty is weighing on confidence and the domestic economy looks set to come under pressure as inflation begins to weigh on consumption,” the investment manager said. It was notably more optimistic on the wider European equity market where it said: “Valuations are attractive.” Anthony Peters, a veteran fixed-income broker, struck a gloomier note and told readers of his daily newsletter that indexes hitting records could mean “there is something resembling an asset price bubble developing but I don’t think it is about to burst. Stay along.”

Meanwhile, two leading forecasters have warned that the squeeze on household finances could push Britain into recession over the coming year, two. A combination of inflation and stagnant wages will put the brakes on consumer spending — the mainstay of the economy since last year’s EU referendum, according to Fathom Consulting.

With the consumer “under assault”, the research firm said there was “now a greater-than-evens chance of a technical recession in the UK over the next year”. The warning came just days after a surprise dip in the rate of inflation. Cheaper oil and a slide in food prices pushed the consumer prices index down from 2.9% in May to 2.6% in June. Nevertheless, the rate of inflation continues to outpace wage growth. Fathom warned that inflation had “merely paused for breath” and would rise again later in the year. Unless pay packets keep pace with the rising cost of living, “consumers’ real purchasing power is reduced”, it added. Economists at Credit Suisse have also warned of the dangers of a recession in Britain, saying there is a roughly one in three chance of it happening over the next few months.

Consumer prices in the United Kingdom rose by 2.6 percent in the year to June 2017, easing from a four-year high of 2.9 percent in May and missing market expectations of a 2.9 percent gain.

In a note to clients, they said a recession “is not our central scenario but the risks are increasing, and the volatile political backdrop and unpredictable Brexit negotiations have increased the uncertainty of our forecasts”.

Meanwhile, second-quarter GDP figures confirmed the slowdown since last year. This was a minimal improvement from the sluggish 0.2 per cent growth recorded in the first three months of the year, which was the slowest quarterly growth of any nation in either the European Union or G7. This confirmed that the UK economy has experienced a “notable slowdown” in the first six months of this year, and effectively kills off the chance of an imminent interest rate rise by the Bank of England.

Also, the consumer confidence index by GfK recorded a 2 point drop in July, fuelled by a 5 point drop in expectations about the general economic situation over the coming year. The company said that overall consumer confidence was at its lowest level since July last year, falling to a balance of -12. A separate report by Lloyds said that only a third of consumers they had surveyed felt good about the country’s financial situation, down from 45 per cent in June last year. It said that most people continued to report concern about current levels of inflation.

These are just some of the recent ‘red flag’ warning signs that continue to emerge in the UK of a possible asset price bubble and economic downturn in the foreseeable future. It forces us to question where we sit in the wider global business cycle and – most importantly – when is the next recession due? Unfortunately, business cycles are hard to age, in part because no two cycles are exactly the same. Predicting the timing of recessions with accuracy is even more difficult. Indeed, economists have a notoriously bad reputation for calling recessions ahead of time. When cycles come to an end, we typically see deep and rapid adjustments in economies and markets as recessions take hold. There are also reasons to believe that the next global downturn could be painful thanks to high aggregate debt burdens and limited policy ammunition.

Consequently, the Reeves Investment Team judge that it appears prudent to start to disinvest in the UK and some other selected global markets, in the current economic climate. In broad terms, our current investment strategy centres around reducing some of our major equity market exposures and drip-investing in to selected corporate bond funds over time to help mitigate inherent timing risks from ongoing market fluctuations. This will reduce the level of risk exposure to a possible equity market correction, whilst securing an increasing & resilient yield return from selected, secure ‘investment grade’ corporate bonds within well-managed, diversified specialist funds. Further specific details will be communicated shortly.

Europe

The growth of business activity across the eurozone slowed unexpectedly last month, as a stalling services sector offset the strongest showing by manufacturers in more than six years. The latest IHS Markit composite purchasing managers’ index gave a reading of 55.7, down from 56.8 registered in both May and April, the highest since April 2011. Any number above 50 indicates growth. Economists had forecast a far healthier reading of 56.6 and none had predicted such a large fall. However, with growth in the eurozone still in positive territory, most experts remained untroubled.

European bonds and shares fell and the euro rose immediately after eurozone policymakers signalled that they were inching towards starting to withdraw their gigantic stimulus package across the 19-nation currency area.

Europe will be one of the major market sectors where we intend to de-risk our equity investment exposure.

US

A sharp rebound in consumer spending boosted America’s gross domestic product between April and June this year, but growth was revised down for the first quarter and for last year. US GDP growth accelerated to 2.6 per cent annualised in the second quarter, the commerce department said in its first estimate. The figure was in line with economists’ forecasts. The solid second quarter will increase the likelihood that the Federal Reserve will raise interest rates again this year. Some economists had suggested in recent weeks that the chances of the Fed’s planned third rate rise this year were diminishing because of weakness in some economic readings. The consensus among economists is for growth of 2.2 per cent for this year. President Trump is seeking growth of 3 per cent by 2021.

The International Monetary Fund poured cold water on President Trump’s economic plans recently, when it cut its growth forecast for the United States. The IMF said that the “extremely optimistic” growth envisaged was “unlikely”, even if the White House pushed through sweeping tax cuts and a huge boost to infrastructure spending. Growth was revised down to 2.1 per cent from 2.3 per cent this year and to 2.1 per cent from 2.5 per cent next year. The IMF predicted growth of 1.8 per cent in 2020, far below the 3 per cent forecast in Mr Trump’s first budget. That budget, published in May, was based on the assumption that plans to spend $1 trillion on infrastructure and to cut personal and corporate taxes would prompt extreme growth. The proposals have stalled in Congress.

The US will be one of the major market sectors where we plan to de-risk our equity investment exposure.

Electra Private Equity PLC

Earlier this year, we identified and selected a new investment trust company, Electra Private Equity PLC, which we introduced to our Adventurous & Aggressive investment portfolios. Although the market price is down 54% over the year following the two recent substantial special dividend payments, the adjusted price is up 47.6% over the same period and well above its Private Equity benchmark comparative (LPX United Kingdom) .

The company is evidently undergoing a period of transition. This period of change is the result of tactics pursued by activist investor Edward Bramson. Throughout 2015, Mr Bramson mounted a sustained campaign against the board of Electra Private Equity. Having built a 30 per cent stake in Electra Private Equity through his investment vehicle Sherborne, Mr Bramson joined the board in November 2015. He then pushed for a review of its investment strategy and structure, before becoming interim chief executive in May 2016. As Chief Executive, Mr Bramson initiated a series of asset disposals, resulting in a £1.4 billion cash pile. This prompted the company Board to return some excess capital to shareholders via two substantial special dividends, which Reeves clients have benefitted from.

The results of the second phase of Electra's strategic review will be announced in the fourth quarter of 2017. In advance of this announcement, the Reeves Investment Team has approached Electra PLC, requesting some interim clarification on the company’s ongoing investment strategy, following recent asset disposals which funded the two special dividend payments. The company has not been forthcoming with any information, despite repeated requests. This has obviously prompted us to question our confidence in the company and in the absence of any meaningful dialogue with senior management, we have judged it prudent to disinvest from Electra PLC in the interests of our client, due to the level of uncertainty. Further information regarding this specific issue will be communicated shortly.