23 May 2017

Relative value in the UK mitigates need to hedge UK risk

2016 demonstrated that what could be perceived as bad for the UK economy can be good for UK markets.

The FTSE 100 has benefitted from sterling weakness and a rebound in commodity prices. This has negative connotations for domestic inflation but positive implications for FTSE 100 earnings. I expect the UK market to be supported by an improved environment for the financial sector whilst inflation concerns may be tempered by continued fierce competition amongst retailers who will absorb cost rises in their margins.

In the West we live in an age of heightened political turmoil where incumbents have been unseated by new entrants and yet markets have at times appeared undaunted by these remarkable developments. One could be forgiven for thinking that the relationship between politics and markets has broken down. However, given the polarisation of the political offering over the last two years in the UK, a Labour victory in the General Election would almost certainly have serious n egative implications for the economy and the UK market.

This current uncertainty, particularly in Europe, has significant implications for markets. In the last eight years markets have been driven in large part by the coordination of global monetary policy. This in turn is borne of a pressure that encourages politicians to ignore the long term debt and non-debt obligations (pensions, healthcare, and social security) in favour of short term pain relief. This has created a negative feedback loop of more debt, greater servicing obligations and lower global growth. Politics and markets are inextricably linked but whatever the election outcome I do not expect the next Government in the UK to address this issue given a lack of international will to do so.

In terms of mitigating the political risk, the approach I have taken in the last few years has been to hedge domestic UK risk with higher weightings outside the UK than would have been the case in the past. The Scottish Referendum, the General Election in 2015 and then the EU Referendum meant that I did not change this stance throughout on the basis that much of the risk would manifest itself in currency weakness. Today, as we approach another political event I take a slightly different view. Sterling is trading near a ten year low against the dollar and we can find better relative value in the UK domestic market than has been the case for a number of years. I am more inclined to diversify using alternative assets and hold index-linked gilts for inflation linked exposure at this point in time.

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