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Reflecting on 2016

Posted by David Stevenson on 09/Jan/2017

It has been an extraordinary end to an extraordinary year. Most notable events have been political in nature, and whilst active investment management will always be about the specifics of individual companies, 2016 has been a timely reminder that the wider environment can have a significant influence on investor returns.

We started the year with uncertainty about the global economy. Slowing growth, particularly in emerging countries, and fears about China’s debt burden, exerted downward pressure on the UK market. A slumping oil price was further evidence of a lack of international demand drivers. As has been the case ever since the 2008 financial crisis, the cavalry once again arrived in the form of central bank policies. In the first quarter both the Bank of England and the ECB made announcements – a delayed rate rise from the former and further monetary stimulus from the latter. A continuation of ultra-loose policy boosted investor spirits, with UK equities enjoying a strong rebound. This returned the market to a marginal gain for the year, immediately prior to the EU referendum in June. The initial panic which followed the unexpected outcome caused stocks to fall – but only by about 7%, and only for two trading days. Rapid transition to a new government, plus a lack of any deteriorating macroeconomic data, saw momentum return to UK equities, driving them to a high point in early October with solid double digit gains for the year. In the lead up to the next big political event - the US election in early November - the UK market gave back some of its performance, but bottomed quickly after the Trump result, and then rebounded. The catalyst for the rebound this time was a belief that Trump’s presidency will herald the reflation of the US economy, built on tax cuts and infrastructure spending as policy switches from monetary to fiscal stimulus. Resurrected inflationary threats then caused bond markets to sell-off, further encouraging a movement towards equities. Back in the UK, the Chancellor’s Autumn Statement also offered the prospect of government investment through additional funding for transport infrastructure and housing. Equity markets have become so comfortable with the new fiscal regime that the Federal Reserve’s tightening of monetary policy in mid-December appears to have caused little volatility.

To date, UK equities have generated a decent, mid-teens total return for 2016, albeit the route to achieving this has been buffeted by political noise. Large companies have been the best performers as their predominantly overseas earnings benefit from sterling’s weakness post the EU referendum. Mid-caps have suffered from the flip side of this currency shift, and have been the worst performers on concerns that their predominantly domestic earnings will eventually be exposed to rising costs from imported inputs, plus fears about the wider UK consumer outlook if real incomes are squeezed by inflation. Interestingly, small-caps and AIM stocks have been relatively good performers – both offer significant exposure to some of the best structural growth companies in the UK and are less exposed to economic or political sentiment. In addition, AIM has a material weighting in resources which have been far and away the best performing segment of the UK market as commodity prices have bottomed.

After such a year, it would seem foolhardy to make sweeping predictions for 2017. Even if the fundamental picture suggests that the UK All-Share now sits at a lower twelve month forward multiple than last December, for more than three times the expected earnings growth of last year (mostly from upgraded resources and financials), it is likely that investment outcomes for next year will again depend on some major political events. Trump’s domestic policies will need to have the consent of Congress, and whilst republicans enjoy a majority in both houses it is traditionally a party which favours fiscal restraint and non-interventionist government. Even if stimulus wins the day, the prospects for the US domestic economy could be overtaken by the upcoming elections in Europe, where the recent Italian referendum result suggests an unstable status quo. EU disintegration would not be a very supportive backdrop for the global economy or the performance of capital markets. There is also the small matter of the UK’s EU exit and trade renegotiations, but increasingly these appear to be risk events for 2019 and beyond. Political uncertainty looks likely to influence investment returns for some time to come.