Robust US economic activity is underpinning the economic expansion, but trade tensions in particular are weighing on sentiment, given their potential to disrupt corporate supply chains and dent business confidence.
The range of economic outcomes ahead has clearly widened, although our indicators suggest that consensus forecasts have now become too bearish, especially in the US, as fiscal spending picks up into year-end.
Tightening financial conditions globally, driven in part by higher short-term interest rates and a stronger US dollar, have created a trickier environment for risk assets, exacerbating the troubles of those emerging markets with weak fundamentals in particular.
Our base case for Brexit sees a withdrawal deal being reached that unlocks a two-year transition period.Our global outlook into year-end remains broadly pro-risk but we place increasing emphasis on building portfolio resilience. US stocks’ robust earnings outlook makes them our top pick, and we focus on higher quality exposures across both equity and fixed income markets. We have not yet lost faith in emerging markets where valuations now reflect significant downside risks.
Investing amid rising uncertainty is not a new theme for UK investors.
Our base case for Brexit sees a withdrawal deal being reached that unlocks a two-year transition period. Yet, as the nation’s scheduled exit from the European Union (EU) next March rapidly approaches, solutions to the complex Irish border issue in particular have proved elusive, and the nature of the future of UK-EU trade relations remains unclear.
Our proprietary macro indicators point to 12-month forward consensus estimates for UK growth standing at steady, albeit unspectacular, levels of 1.3 per cent by year-end. This is lower than prior to the 2016 referendum (and also most other developed markets today), but better than the gloomier forecasts ahead of the Brexit vote.
Consumer confidence is holding up, and subdued productivity growth suggests that a tepid pace of growth may be enough to keep the labour market tight. A mild bounce back in second quarter GDP supports the view that the previous quarter’s particularly weak performance was more a reflection of the bad weather, not the business climate.
UK core inflation has proved to be sticky at around 2 per cent, thus vindicating the Bank of England’s August decision to raise rates for only the second time since 2007. If UK core inflation remains around current levels (a view supported by our indicators on a six-month horizon), we do not expect further policy tightening until more clarity emerges regarding the UK’s exit from the EU.
With crunch time approaching, our base case scenario remains that pressure to avoid a no-deal outcome will ultimately result in a compromise, with a transition period beginning in March that may subsequently be extended.
Yet a souring in UK-EU relations after the informal “Salzburg Summit” makes an already bumpy path ahead now look even more jagged.
Although some may argue that the events in Austria now render a “no deal” Brexit more likely, we remain confident that an agreement can still be reached. Signs of a compromise from either side on the Irish border backstop, for example, would be a key indicator that a withdrawal deal is becoming more likely, and such signs are now emerging.
The willingness of both parties to tolerate a “blind Brexit”, whereby all decisions on the future relationship are kicked down the road, will also be crucial, although this would come at the cost of potentially creating another cliff-edge further down the line.
In line with our global views, we focus on fortifying UK investor portfolios in the face of elevated macro uncertainty. We are more cautious on UK stocks relative to other regions, particularly given the weaker earnings outlook.
That said, the global nature of large scale British industry does still allow domestic investors to gain significant exposure to faster-growing regions. Over 70 per cent of FTSE 100 company revenues are generated overseas, according to Factset data, and 18 per cent are generated in emerging markets – a high proportion relative to other developed markets.
Valuations, meanwhile, have also adjusted significantly: UK equities are currently trading at their biggest discount to other developed markets since 2010 on a 12-month forward P/E basis.
The hit to sentiment has not only impacted the weakest UK companies. As a result, we now see particularly good opportunities for returns in consumer and business service industries with strong business models, and lean towards those stocks with high proportions of international earnings.
In the real estate markets, we focus on the highest-quality assets in line with our preference for fortifying portfolios amid macro uncertainty.
With Brexit-related noise set to get louder over the coming weeks, we expect sterling and UK gilts to remain twitchy to political news. If negotiations do eventually result in a deal that enables uncertainty to lift, UK interest rates and the pound will need to re-price higher.
Within UK credit markets we favour the industrial and utilities sectors, and also see hedged European credit as relatively attractive for UK fixed income investors.
We expect strong institutional demand to apply ongoing downward pressure to long-end UK yields across corporate and government debt.
Whatever Brexit brings we should be trained to see opportunity.
Clarity on the future UK-EU relationship may yet be a long way away, but good prospects exist both within and outside the UK for those willing to look beyond the day-to-day headlines.
Richard Turnill is global chief investment strategist at BlackRock
