Gervais Williams, head of Equities at Premier Miton, looks forward to the passing of the uncertainties around Brexit but warns there is a growing risk to stock markets should a geo-political setback occur.
The key economic trend over the last twelve years has been the growth of Chinese borrowing, to fund additional infrastructure spend and global expansion. At times when Chinese borrowing has slowed, the G7 central banks have lowered bond rates and stimulated the growth of bank lending. Economic growth may have been relatively modest over the last decade, but as bond yields have fallen progressively, corporate valuations have steadily appreciated alongside. This appreciation of valuations was most marked amongst those with strong growth stories. Overall, most stock markets have delivered annualised returns well above inflation since 2008, on the back of economic growth due to Chinese infrastructure investment, and the rise in asset valuations as bond yields have fallen.
The plentiful investment into Chinese infrastructure comes with the disadvantage that over time the projects progressively generate ever-lower cash paybacks. For example, the returns on many infrastructure projects have now deteriorated to a point where the payback is so low that it’s increasingly difficult to find international banks willing to lend. The setback in Chinese infrastructure spend over the last couple of years has led to global growth falling back to desperately low levels. Recent market appreciation has been wholly driven by G7 banks’ lending debt in spite of lending margins being incredibly low.
In continental Europe, government bond yields have now fallen to negative levels and margins on commercial lending are unprofitable, so few banks are willing to lend locally at present. As economic growth grinds to a halt, mainstream stock market returns are unlikely to be particularly attractive in the coming year or two. Investors will need to concentrate on picking out individual stocks that can buck the wider trend.
In contrast, US bond yields still offer banks a lending margin, and this might lead to a pick-up in corporate borrowing and buy backs of their shares. Although economic growth might not accelerate much, the US stock market could melt up further as valuations move higher. Overall, we believe small caps have the greatest scope to outperform.
UK prospects
In the UK, as the uncertainties of Brexit drop away, its upside potential appears to be much greater. First, the UK stock market is due a period of valuation catch-up with other G7 comparatives. Second, it seems likely that there will be a release of investment spend too as there is greater confidence in the future. Overall, we expect the UK stock market to be one of the best performers going forward, especially within domestically focused businesses that are mainly outside the FTSE 100 Index.
Since stock markets haven’t suffered a significant setback for over a decade, all investors should recognise that there is a growing risk of a drawdown in stock markets when a geo-political setback occurs in the future. Stock market valuations could suffer a setback, and the geo-political setback might lead to a global recession. It is noteworthy that with bond yields already at ultra-low levels, central banks have effectively no scope to stimulate a stock market recovery similar to that of 2009.
Active strategies will need to be willing to invest across a wide investment universe to maximise their ability to capture returns that aren’t particularly related to the general appreciation of stock markets. The key exceptions could be the UK and to a lesser extent the US. Alongside this, we believe it is also a time when most strategies should be wary of balance sheet risk, or the participation in emerging markets unless G7 banks exhibit a change of heart and decide to step up their lending.
