By Tom Elliott, deVere Group’s International Investment Strategist
This week: That was the Fed summer rate hike that wasn’t. Brexit fears cause sterling weakness and highlights the need for investment diversification. Brexit and house prices cause dilemma for the younger voter.
The most significant near-term risk for U.K investors is of a sharp fall in sterling in the event of Brexit. More generally, and of greater significance, the risk of a hard landing for the Chinese economy rumbles on a Beijing’s approach to each period of soft growth is to encourage more private sector borrowing which is increasingly less effective at stimulating GDP growth. Lurking in the background are the risks of irresponsible U.S governance should Donald Trump become president in November and central banks’ inability to escape the ultra-low interest rate environment that they have created.
But when have investors not faced a ‘wall of worry’? History shows that a diversified, multi-asset portfolio is the best protection against such worries, and offers superior risk-adjusted returns compared to a portfolio of only equities or only bonds.
In the near term, with the U.S Fed no longer likely to raise interest rates in the summer, higher dividend paying stocks and riskier bonds in developed markets may outperform. In the bond market, investors’ hunt for yield by extending duration exposure will persist, particularly in the euro zone where 50 year and even 100 year bonds (from the governments of Spain and Belgium) have been issued. The ECB appears increasingly willing to buy anything, and everything, that is issued by companies and sovereigns.
That was the Fed summer rate hike that wasn’t
The recent and curious rally in U.S. stocks must now be over, together with expectations of a summer rate hike from the Fed, after Friday’s poor May employment data.
A net 38,000 new jobs were created in May, against expectations of a gain of 162,000. Even taking into account the 35,000 striking Verizon workers (which count as job losses), the figure is very disappointing. In addition, estimates of jobs growth in previous months were downgraded.
The fall in unemployment to 4.7% is only superficially good news, it is in large part due to a rise in the labour non-participation rate (ie, it reflects an increase in the number of working age Americans who are considered no longer available for work, so are not counted as unemployed).
Until Friday’s poor employment data, investors in U.S equities had been pricing in – at a higher than evens chance- a Fed rate hike in June, or July. Furthermore ever louder hints of rate hikes from the Fed had been interpreted as ‘good news’ by investors, since regional Fed governors, and Fed Chair Janet Yellen, had begun talking of strengthening economic conditions three weeks ago. By Thursday the S&P 500 index looked set to pass its previous May 2015.
One might have argued, as I did in last fortnight’s Riding the Camel, that GDP growth and inflation data provide little justification for a June or July rate hike. The disappointing Q1 GDP growth of 0.8% at an annualised rate led many to wonder if December’s rate hike had been a mistake, while estimates of 2.5% GDP growth in Q2 (eg, from the Atlanta Fed on Friday) hint more of the continuing pattern of instability of the US economy that we have seen since this economic cycle began in 2009 than of sustainable and robust economic growth. Particularly given declining labour productivity numbers, weak wage growth, and still-modest core CPI inflation of 1.1% y/y.
Brexit fears cause sterling weakness and highlights the need for investment diversification
Sterling looks set to be volatile over the coming three weeks, subject to Brexit poll results and newspaper headlines. In May the currency benefited from investor consensus that the Remain campaign would win the 23 June referendum, but the pound fell 3 US cents in the 10 days to Thursday, before recovering a little on Friday to close at $1.45. Sterling weakness is in response to polls that have suggested for the first time in months that the Leave campaign may now win the referendum. The cost of insuring against movement in the currency against the dollar rose sharply. The one-month implied sterling volatility contract (which now covers the vote date) rose to over 20, its highest level since Feb 2009, though still well below the record high of 31 reached in October 2008.
Sterling’s volatility highlights a problem which many investors share. This is the ‘home bias’ problem in investing, whereby we favour those markets that we are most familiar with, irrespective of the vulnerability to idiosyncratic events in our home that this creates (such as a bout of currency weakness). The U.K currently has a weighting of 7.1% of the MSCI World index, there is no investment-led reason for a U.K investor to be overweight that figure unless he/she believes that British companies will outperform those of overseas markets, in which case an overweight up to perhaps 14% might be justified.
A Guardian / ICB poll last week showed a 52-48 lead for the Leave campaign. The debate has returned to immigration, triggered by the release of the official 2015 migration statistics on 26 May which showed a net migration inflow of 333,000 last year -the second largest net inflow on record and 20,000 larger than 2014. This was largely due to a fall in emigration numbers. The large net figure shows the futility of Prime Minister David Cameron’s 2010 pledge to reduce net migration to below 100,000 – ‘no ifs, no buts’, a broken promise that has been fully exploited by the Leave campaign. Immigration from other E.U countries makes up just under half total immigration, but is rising sharply. Last year more new jobs in the U.K went to other E.U citizens than to British workers, in part reflecting the tight U.K labour market with current unemployment at 5.1%, compared to 10.2% in the euro zone.
Brexit and house prices cause dilemma for the young voter
Neither side in the campaign wish to address a possible outcome of a vote to leave, which is to trigger a fall in house prices. There is good reason to believe that house prices in Britain will fall over the coming years anyway, given their current overvaluation (by historic standards) in much of the country. Furthermore, measures introduced by the current government to deter buy-to-let investors, and increased transparency on overseas buyers, have already seen weakness in parts of the London market emerge over the last 12 months.
Brexit might hasten this process, through prompting a rise in inter-bank lending costs (due to economic uncertainty) which then raises mortgage costs. This puts younger voters, who would most benefit from cheaper house prices, in a dilemma over how to vote in the referendum since they are also most likely to vote Remain. It also creates a dilemma for both the Leave and the Remain campaigns, with the Leave side receiving much of its support from older people who will be home owners and nervous of any risk to house prices, while the Remain side receives much of its support from younger people who would -ironically- be prime beneficiaries of a drop in house prices as they look to buy first homes.
Indeed, the demographics show a strong trend whereby the older and less educated a voter is, the more likely it is they will vote Leave. The opinion pollster YouGov suggest that there is a 40% majority to remain amongst 18-29 year old, and a 23% majority amongst 30-39 year olds. Meanwhile those aged 50-59 have a 10% majority in favour of leaving, while a 25% majority of 60+ wish to leave. Meanwhile those aged 60+ are considered more likely to actually vote than any other age cohort, with 18-29 year olds the least likely.