Investors should remain focused on quality assets and not get carried away by promises of fiscal stimulus and rising bond yields, according to Rathbone’s Edward Smith and Julian Chillingworth’s latest investment update.
The asset allocation strategist and chief investment officer say that, while many believe ultra-loose monetary policy will soon taper off and will be replaced by fiscal stimulus, geopolitical constraints are far more binding than people think. 
This warning comes following last week’s Autumn Statement, when chancellor Philip Hammond announced a fiscal stimulus programme funded by borrowing approximately £16bn over the course of the current parliament.
While Smith and Chillingworth (pictured) believe fiscal spending is needed to boost the economy, they say this amount is meagre given the Office for Budget Responsibility (OBR) estimates that the current government will borrow £93bn over the rest of its tenure. They warn that this high level of borrowing is expected because economic growth is forecast to slow following the vote to leave the European Union.
In fact, Smith and Chillingworth describe the proposed fiscal stimulus not as fiscal loosening, but “a little less tightening than was previously scheduled”.
As such, they warn investors not to get too excited about a strengthening UK economy and the impact this could have on markets, which is why they believe rotating out of quality assets into value may not be the best call of action at the moment.
“Public borrowing has not fallen to the extent forecast in the March Budget,” they pointed out.
“Public sector net borrowing (excluding government-owned banks) declined 10 per cent between April and October relative to the same period last year, yet the Budget was based on a 25 per cent fall in this fiscal year.
Cyclically-adjusted public sector net borrowing from 2009-10 to 2021-22
Source: Office for Budget Responsibility
“This now seems well out of reach: the OBR now projects that borrowing for 2016-17 as a whole will be £12bn higher than forecast in March. This could quite easily be higher still.
“While we still do not expect the vote to leave the EU to precipitate recession, our five preferred survey-based leading economic indicators of business, investment and consumer activity all point towards a significant slowdown – possibly to the point of stagnation – in the first quarter of 2017.”
Smith and Chillingworth also warn that uncertainty around leaving the EU could reduce private investment or cause the price of imported goods to rise if sterling weakens, thereby lowering government receipts.
They are not alone in believing this will be the case. According to the pair, the average growth forecast for 2019 collected by HM Treasury has fallen from 2.1 per cent in May to 1.6 per cent this month.
They also point out that, according to the Institute for Fiscal Studies, borrowing would increase by at least £13bn if the economy were to shrink by just 1 per cent more than it is forecast to by 2020.
That said, they say the chancellor’s £23bn allocation to a new National Productivity Investment Fund is a step in the right direction, despite amounting to just 0.3 per cent of GDP.
“Remember that Mr Osborne cut public investment to the lowest level since the 1990s. Earlier this year the International Monetary Fund urged all countries to adopt policies that would increase spending on research and development by 40 per cent in order to raise productivity and improve welfare,” they continued.
“Presumably it would encourage those countries that have fallen behind in productivity to do even more? The additional funding announced for this parliament increases total R&D by just 2.3 per cent.
“Tax breaks on R&D would be better and could help to capture the significant foreign direct investment multinational firms are planning in the area, offsetting some of the costs of withdrawing from the single market.”
In terms of other measures announced by the chancellor that have equity market implications, Smith and Chillingworth say the £1.4bn committed to building an extra 40,000 homes is nothing to get excited about, given that it amounts to just £35,000 per home.
While they say this is not enough to significantly reduce house prices, they point out that today’s high price-to-rent and price-to-income ratios mean prices are unlikely to continue growing at the pace they have been over the last 10 years.
Overall, the pair are indeed sceptical of how healthy the UK economy will remain over the medium term given muted fiscal stimulus and current growth forecasts.
However, they also believe the global economy may remain weaker than expected as European countries are unlikely to see any fiscal spending and Trump’s proposals for fiscal expansion may be quashed by other members of his party.
“Globally, many investment strategists expect loose monetary policy to hand over to looser fiscal policy next year, and forecast that bond yields will continue to rise accordingly. We believe that political constraints are more binding than many believe and the Autumn Statement only adds to this thesis,” Smith and Chillingworth continued.
“While many are excited about president-elect Donald Trump’s promised fiscal splurge, we believe that the fiscal hawks in his own party will delay and ultimately water down his proposals considerably.
“Meanwhile, the European Commission last week released an overlooked paper, ‘Towards a positive fiscal stance for the Euro area’. Although this sounds positive, it made it clear that only countries abiding by the Stability and Growth Pact (i.e. with budget deficits no greater than 3 per cent and debt less than 60 per cent of GDP or ‘diminishing at an adequate rate’) should undertake any fiscal easing.
“This leaves only Germany, whose council of economic advisors judged earlier this month that such action could cause inflation to overheat.”
Given this backdrop, they believe bond yields will be driven by commodity prices, currency and the need for further quantitative easing in Europe, which is dependent on next year’s political events.
“All of these are notoriously hard to predict, and we encourage investors not to get carried away with trades predicated on bond yields continuing to rise and yield curves continuing to steepen,” Smith and Chillingworth warned.
Performance of indices over 3months
Source: FE Analytics
“Many stocks and sectors have already moved sharply relative to the rest of the market. As the chancellor underscored, uncertainty still prevails, and quality, cash-compounding companies with strong returns on equity are likely to continue to offer the best risk-adjusted returns.”