The outlook for equities in 2017 is clouded by significant political risks, such as Donald Trump and his proposed reflation policies, Brexit/Article 50 and European elections to name but three, and the knowledge that the US Federal Reserve is likely to raise interest rates further from what are still historically low levels.
There are also concerns that the Fed may eventually have to accelerate the pace of interest rate rises if Trump’s reflationary policies take off, meaning that the market could be complacent on where interest rates might be headed in the longer term.
In this environment, we believe that focusing on stock-specific opportunities makes much more sense than making brave, but potentially dangerous, assumptions about whether markets will rise or fall, or what might happen to currencies, bond prices or the price of commodities, such as oil.
These factors are very hard to assess correctly and can result in significant portfolio drawdowns, when investors get them wrong. For stock pickers, it is encouraging that the dispersion of returns for individual stocks remains at high levels; this provides a wide and attractive range of opportunities for active investors.
Crucially, by investing across a range of stocks, through both long and short positions, opportunities can be explored whilst maintaining very low levels of exposure to the unpredictable currency, bond and commodity price risks that we have outlined above.
Performance of fund vs sector in 2016
Source: FE Analytics
Both pre and post the UK’s referendum on EU membership, we have seen the use of Brexit ‘winner’ and ‘loser’ trading baskets.
This has meant that the market has, in our view, overly focused on US dollar earners and not always paid enough attention to the strengths or weaknesses of the underlying businesses.
Currency weakness could prove to be temporary, but ongoing problems across a range of industries, such as the inability to raise the price of goods due to weak demand, are likely to prove more challenging and time consuming to resolve.
The market’s focus on Brexit ‘winners’ and ‘losers’, while often ignoring the strength or weaknesses of the underlying businesses, is creating opportunities to add value in both long and short positons, as the market see-saws between dollar earners/weak pound one day and Brexit losers/strong pound the next.
Currency moves, without doubt, have changed company economics since June last year and will continue to do so in 2017.
Performance of sterlng vs dollar in 2016
Source: FE Analytics
We are not currency experts but we do think that the market will have to recalibrate the revenue and cost implications of a weaker pound, a potential ‘forced de-globalisation’ led by Trump and potential retaliation from the likes of China. For retailers, the headwind from low/no real income growth in 2017 could be material and we are monitoring developments closely.
For the UK specifically, we expect Brexit to dominate the narrative in 2017 and, barring any significant external events, it looks like Theresa May’s success or failure as prime minister will be defined by how she deals with Britain’s exit from the European Union.
Those who voted for the UK to remain in the EU and single market will inevitably feel less confident about the future, given the latest rhetoric, and it will be important to monitor how this impacts consumer sentiment and behaviour.
Where we do own consumer-related stocks, we are focusing on those that provide branded goods and, therefore, benefit from the ability to pass on rising input costs to the consumer. Consumers will generally pay up for brands, but tend to be less willing to do so for goods that are viewed as being commoditised.
Performance of FTSE All Share Consumer Goods index in 2016
Source: FE Analytics
Perhaps most crucially in terms of the outlook for 2017, inflation concerns will begin to emerge late in the second quarter or early in the third quarter as the large year-on-year slump in the pound begins to wash through the system.
This points to a fairly unpleasant outlook for UK real incomes, although some companies, particularly those lacking the ability to raise prices or facing weak end markets, will be forced to share some of the pain. Last year’s Unilever/Tesco spat is, in our view, a sign of things to come.
All this adds up to a broader opportunity set for long/short investors, particularly if we start to see larger and more frequent profit warnings and greater dispersion of stock returns.
We believe that the ability to short sell in particular will be an important driver of returns, in an environment where UK equities have run far and fast despite the deteriorating growth and inflation outlook.