Why it may be time to reduce investment exposure to UK
Two trends have dominated financial markets in recent months: global growth has continued to weaken, while inflationary pressure has eased.
The main cloud on the horizon now is the renewed upward spike in US mortgage spreads; this prevents the average American house-buyer from benefiting from looser monetary policy and lower bond yields.
More positively, energy prices have continued to fall. This should provide room for central banks to help the economy while reducing the uncertainty associated with high inflation.
Taken together, our view is that the balance of risk and return expectations has not changed that much. We still see substantial upside for risky assets on a 12-month horizon, albeit with short-term risk. Looking at regional equity allocations, the UK and Europe are trading at an increased discount to US multiples. This raises the question of whether we should move some of our overweight from the US to the UK, where we have been neutral.
We would not recommend a switch from the US to the UK; the reasons why are mainly cyclical. For a start, the current economic troubles began in the US, so the US is further ahead in both its economic correction and its policy response. Moreover, it has a higher probability of further fiscal policy action.
Earnings Weakness
Also, US earnings are likely to be less volatile than the UK, which has a high weighting towards commodities and an increasingly weak domestic economy. Indeed, the earnings correction could be more serious in the UK, especially if our expectations of a rebound next year do not materialise. Therefore, we have moved to a tactical underweight in the UK.
The other region that has seen most structural changes recently is emerging markets, where we have our other major tactical equity overweight. However, while many like to peddle the “decoupling” story for these economies (and we do agree to some extent), we do not buy this argument on a tactical basis. Emerging markets’ tactical performance is still driven by the same factors which have been evident since the break-up of the Soviet Union – i.e. real interest rates, global liquidity, risk and fear. These are combined in our emerging markets indicator, which currently suggests substantial outperformance in emerging markets relative to the MSCI World Index over the next 12 months.
Incidentally, with many quantitative investment strategies currently struggling to handle cyclical and structural shifts, it is worth noting that this indicator also has a good track record of identifying underperformance in emerging markets. For those investors who are worried about the prognosis for the UK and who are able to switch into other regions, now may be the time to think about reducing UK exposure, perhaps in favour of emerging markets. Those who can’t should expect a a bumpy ride.