Beyond Bulls & Bears

Equity

The Great Sector Rotation, and the Road Ahead for UK Equities

Equity markets across the globe reacted to key events in 2016 in ways investors may have not expected, and the UK equity market was no exception. Ben Russon, vice president, portfolio manager, Franklin UK Equity Team, weighs in on trends he has seen in the UK equity market, and why investors should brace for a period of inflation in the United Kingdom.

Global equity markets witnessed significant changes in 2016, prompted in part by the result of the Brexit referendum, the US presidential election and the upward movement in interest-rate expectations—particularly in the United States. We think those developments will serve to set the tone for 2017. In particular, we expect the United Kingdom’s decision during 2016 to leave the European Union (EU) to continue to cast a long shadow well into 2017 and beyond, particularly as uncertainty about the exact details persists.

As we look forward to the New Year, we think investors are likely to be more aware of the potential for major macro events to spring surprises. And although investors are likely to be factoring in the possibility of a wider range of eventualities from the French and German elections scheduled for 2017, “anti-establishment” results still have the potential to disrupt global equity markets and change the investment landscape.

The Great Sector Rotation

In the closing months of 2016, there were big changes in some of the financial metrics that feed into economic assumptions and indeed equity valuation assumptions, and we think that sets the tone for where we move into 2017.

Equity markets witnessed a sharp rotation that has seen short duration or cyclical stocks, which tend to rise and fall in line with economic trends, advance ahead of their defensive counterparts, where valuations have pulled back. Expectations for US fiscal stimulus, reflation and rising US interest rates were the catalyst for such moves, exacerbated by the proposed policy objectives of President-elect Donald Trump. As Trump assumes office, we are now entering the phase where we can begin to judge what policies can actually be implemented, and what impact rising rates will have upon the US consumer.

Recovering oil prices will also contribute to an increase in headline inflation. Some commentators seem to be of the view that the price of oil can consolidate around the current US$50–$60 per barrel range. Even without further oil price increases in the year ahead, oil will contribute to inflationary pressure in the short term because of comparisons with historically low prices at the beginning of 2016.

Brexit’s Long Shadow

The big unknown hanging over the United Kingdom as we enter 2017 is, of course, Brexit.

Currently, we don’t know what form Brexit is likely to take nor indeed if and when it will actually occur. There is still an outside prospect of Prime Minister Theresa May calling an early general election, and some commentators have even suggested that another referendum is not out of the bounds of possibility. The course of events over 2016 has at least conditioned people to take a broader view on potential political outcomes.

UK consumers have yet to see the impact of inflation really starting to bite. The Brexit vote led to an immediate reaction in the currencies—a depreciation in sterling against a strong US dollar—which is expected to impact firms as they face higher business costs, and consumers as they absorb negative real wage growth. With the savings ratio approaching historical lows, there are few avenues available for the consumer to cushion such blows.

There are still many unknowns for the United Kingdom surrounding inflation, the growth of the economy and the ultimate terms of Brexit, and we expect such uncertainty to delay investment decisions. UK gross domestic product growth expectations were downgraded following the Brexit vote in June.1 Domestic sectors such as retail, leisure and house-building de-rated through the latter half of the year, reflecting the inherent uncertainty of the political and economic situation in the United Kingdom. And, in my view, these sectors may likely struggle to re-rate until the fog clears up a little.

Meanwhile, the absence of any new UK fiscal stimulus measures from the recent Autumn Statement suggests to us that the new Chancellor of the Exchequer, Philip Hammond, wants to keep his powder dry, recognising there are likely going to be further bumps in the road ahead. In the same way, we think the Bank of England’s Monetary Policy Committee will likely adopt a cautious approach, because it seems to have come to the same conclusion. We wouldn’t anticipate much change in UK monetary policy in the year ahead.

The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

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What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

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1. Source: International Monetary Fund, World Economic Outlook, October 2016.