Brexit – what’s next?
The uncertainty preceding the UK’s referendum on EU membership and the shock which followed the Leave vote presented an environment which was difficult to navigate for many investors.
But with a number of fresh obstacles to a benign investment environment looming on the horizon – from the prospect of president Trump to the possibility of Italy’s referendum kick-starting fresh political turmoil in Europe – we may be able to take some referendum lessons forward.
As managers of an absolute return strategy, one of our key concerns at the moment is complacency. Despite a consensus that the Brexit process will have a negative short term economic effect (while the longer-term impact remains the source of much debate), stock market levels are showing little sign of factoring in the heightened probability of a recession.
We have developed a proprietary indicator of investor confidence, which is one of the signals we look at when determining the size of our long and short books, and therefore our net and gross market exposure. Investor confidence is still high or, to put it another way, signs of investor anxiety are low. In our experience of monitoring sentiment, this investor complacency, when combined with a market which is down-trending, is usually bad news for equity markets. It raises the prospect of sharp market falls should complacency rapidly evaporate due to any firm evidence that the economy is actually slowing.
Markets are indeed down-trending, and have been since January, according to the technical classifications of market momentum which we employ. This trend has not been broken for the last six months despite a recovery in market levels from mid-February lows which was driven by aggressive ECB action.
The uncertainty in the run up to the EU referendum, and the volatility which followed the result, offers something of a case study of how absolute return strategies can deliver an attractive return profile in such an environment by reducing exposure to volatility and delivering good returns through an asymmetric return profile: i.e. providing some downside protection while maintaining good upside participation in the instance of market recovery
We went into June maintaining a low net exposure due to the unpromising combination of technical indicators and investor confidence noted above. One of the other factors we look at when determining our net and gross market exposure is the proportion of companies burning too much cash. This is because a key component of our long/short investment process is the identification of companies who are sensible or over-aggressive respectively in deployment of their cash flows, with the latter being a determinant of the size of our short book. At the moment, companies are acting fairly conservatively in their cash expenditures, which restricts the size of our short opportunity and means that we have had fairly low gross exposure this year – around 130-140%.
While we would rather find lots of opportunity on both long and short sides, our job is to assess the environment and build a portfolio accordingly, taking account of the volatility profile of returns.
During June this cautious strategy delivered positive returns while the European market’s return was negative. With investor complacency suggestive of further declines in markets, we are not minded to alter our defensive positioning yet.
Our advice to any investors concerned at the number of risk events likely to play out in the remainder of 2016 would be to restrict their market exposure, particularly if they have a low tolerance for volatility, and to adopt a ‘bar-bell’ style profile in their long book. The variation in share valuations of companies across the market is currently very low save for a couple of sectors – energy and materials. In these two sectors it is possible to find attractive value stocks, those whose focus on cash flow management will allow them to recover from downturn in their markets. But elsewhere the majority of the market exhibits low valuation dispersion, and we think that, here, a portfolio emphasis on higher quality stocks that can deliver on growth expectations is wise. In environments of risk aversion, these high quality companies tend to be rewarded as investors seek the safety of strong cash flows and robust balance sheets. In a market correction, when valuation dispersion inevitably widens, value stocks would be expected to move to a wider valuation discount whereas quality stocks can command a higher premium.
We are therefore currently running a combination of broad quality exposure and very selective value picks in energy and materials.
It is clearly important to be ready to adjust this positioning as events unfold. Factors which will need careful management over the next 12 months are the contrast in prospects regionally and for investment over different time horizons. For example, while the UK and European markets are currently in a downtrend, our technical indicators suggest that the US has regained some momentum. But in the longer term, cyclically adjusted price/earnings ratio point to little value in the US, where the multiple has hit 27x, and more opportunities in Europe with an average multiple of 14x.
Our instruments are currently calibrated to a cautious positioning ahead of what is likely to be an eventful second half of 2016, but we stand ready to adjust the levers available to us in order to exploit opportunities on both the long and short sides.
James Inglis-Jones and Samantha Gleave (pictured) are co-managers on the Liontrust European Strategic Equity Fund