Tuesday, September 23rd, 2014

Scotland the Cautious

Financial markets don’t normally care about the constitutional arrangements of the countries they invest in, which is why the Scottish independence vote was so unusual. There was enough of an existential threat to sterling and the UK banking system for the currency and credit markets to take an interest, and as soon as that happened the equity markets were equally concerned. This was loosely described a political risk, but it wasn’t really. It was currency risk depending on the outcome of a political vote. There is more pure political risk involved in the “devolution for England” debate which is just starting. This may well be the defining issue of the next General Election, which is due in May 2015. There is however, very little currency risk – at least not until Q2.

Does this mean that UK equities, can stage a comeback? We think not. Sterling will probably recoup some of its recent weakness against the dollar. We still expect the Bank of England to raise interest rates sooner and faster than the Federal Reserve. But further increases in the exchange rate would not help UK equities, because UK investors are already fretting about the impact on earnings and dividend growth for 2015. Our simple equity vs bonds model has UK equities at a significant underweight and the trend is deteriorating. Even if overseas investors liked the currency appreciation, it would make little difference because domestic investors clearly don’t. They are getting fed up with the meagre risk-adjusted returns on offer this year – 3.9% total return for volatility of 9.9%, compared with 5.4% total return for medium-dated gilts and volatility of 4.0%.

The most interesting thing about the UK is how closely our sector recommendations resemble those for the Eurozone, which is our least preferred equity region. Utilities and Healthcare are #1 and #2 in both regions, and both have very large overweights compared to the rest of the index. At the bottom of the table Materials is #8 in both and Industrials is #9. Every UK sector is within two ranks of its Eurozone equivalent, apart from Technology and Consumer Discretionary. Technology is #10 in the UK and #3 in the Eurozone and the difference is all down to the performance of Nokia. Consumer Discretionary is #6 in the UK vs #10 in the Eurozone for the simple reason that the UK does not have any large-cap quoted auto manufacturers.

If we include Small Caps as part of the sector process we find that they are #10 in the UK and #11 in the Eurozone. This is traditionally a good indicator of risk appetite in pure equity mandates, and it gives an answer which is close to zero. The contrast with US sector recommendations is clear. Healthcare may be #2 in both the UK and the US, but Utilities are #8 in the US (not #1) and Technology is #1 (not #10). Energy is #9 in the US (not #4) and Materials are #3 (not #8).

Our conclusion is that UK equities have decoupled from the US and are now yoked to the performance of the Eurozone. This isn’t permanent but it may well last for the rest of 2014. After that investors will have to deal with rising interest rates and an upcoming General Election.

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