Tuesday, June 17th, 2014

Home Truths From Abroad

Our first point concerns M&A activity, which has been cited as one of the potential drivers of equity returns. Yes, there are overseas companies, particularly from the US, looking to invest cash which cannot be repatriated without incurring significant tax liabilities. However when we last wrote about this topic (Premium Valuation, 30th April 2014) we calculated that it would take a bid for Barclays, Vodafone, and BG Group at the same premium as AstraZeneca to move the FTSE by about 5 percentage points. This still seems unlikely to us. It would also require Pfizer to come back for AstraZeneca in six months’ time.

Our second point is that portfolio investors do not seem to share the same enthusiasm for the UK as their corporate counterparts. In recent weeks UK equities have slipped down the rankings in our US dollar and our euro asset allocation models. In both models they have ranked below US and Eurozone equities since mid- March, apart from the four-week period when the AstraZeneca bid was “live”. Since the failure of that approach, the previous order has been reasserted and the gap has begun to widen. UK equities have also been overtaken by Emerging Markets, which are recovering from the crisis of 2013. They still rank above Japan, but even here we notice a tendency for the UK weighting to fall and the Japanese weighting to rise – admittedly from a very low base.

We think there are at least five reasons for the slide. (1) M&A activity may be a reason for UK investors to hold onto their local market, but it is not a reason for foreigners to buy one which may be on the turn. (2) Sterling strength used to be a positive for overseas investors, but we may be close to the point where the benefit is outweighed by the damage that it inflicts on earnings. (3) Until recently sterling strength came without the immediate threat of rising interest rates. After Governor Carney’s speech last week, the chances of the first increase occurring in 2014 have risen significantly. (4) UK GDP growth has been one the great positive surprises of the last 12 months and it may carry on at the same 3 percent rate (plus or minus) for a few more quarters. But only a “hyper-bull” would bet on acceleration from here. (5) Political risk is rising.

From our travels in Europe and the US it is apparent that overseas investors find it difficult to assess the result of the Scottish independence referendum and the implications of a Yes-vote. They are also aware that there is a General Election in May 2015, and are puzzled by the thought of Conservatives and Liberals campaigning against each other. They also find it difficult to assess the impact of UKIP in the wake of the European Elections. Finally, they are unsettled by the multiple disagreements between the UK and the EU, and have begun to realise that they may be dealing with this issue for at least the next three years. None the above would require overseas investors to sell now, but they are already enough for them to postpone purchases to a later date.

In theory, the UK in three years’ time could be without Scotland, governed by an unstable coalition including a party (UKIP) which was only founded in 1993, and just about to vote to leave the EU. This is not our central scenario, but why should overseas investors take this set of risks before the Scottish referendum, if they don’t have to?

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