Investment Outlook - A More Favorable Perspective for International Equities

Strong market returns in 2019 despite geopolitical overhang

World equity markets have produced strong returns year-to-date, driven by declining interest rates and rising growth stocks. Despite double-digit gains for the MSCI World index, geopolitical gloom, notably trade wars and Brexit, hangs over investors, economies and the share prices of more economically-sensitive companies.

To many observers, the news flow around Brexit seemed to worsen in the third quarter. Boris Johnson took over as prime minister in July and adopted a far more adversarial tone in comparison to his predecessor, pledging to leave the European Union (EU) with or without an agreement on October 31st “do or die.” While his rhetoric is targeted at suffocating a challenge from the recently-formed Brexit Party, parliament, suspicious of the prime minister’s tone and presumably fearful that he might not be bluffing, has imposed itself on proceedings by passing a law compelling the government to seek an extension from the EU on October 19th unless a withdrawal deal has been passed. Although cynics will question whether the government has somehow a means to circumvent this new law, it seems far more likely that the no deal tail risk has, at the very least, been pushed out to 2020. Moreover, although a deal still seems highly improbable given the time constraints and the political constraints, the only path towards honoring the “do or die” pledge would be a negotiated departure.

Practically, a deal would only partially address the Brexit issues, since the wrangling would just start again with more detailed arguments over the structure of the UK’s future relationship with the EU. In the absence of a deal, an extension followed by a general election later in the year or in the first half of next year is most likely. We acknowledge that the Brexit uncertainty and the tail risk of a disorderly Brexit, even if it remains unlikely, will continue to weigh on the UK economy and on the performance of UK stocks. In the short term, this is challenging for the Fund as we see a number of UK stocks as being very undervalued. On a 5.5% starting yield, the UK market would only need a half percent long-term real growth in dividends to offer a minimum of a 6% long-term real return. Even with Brexit, that should be achievable. The UK now looks the most attractively-valued major stock market globally, especially after considering that 77% of the MSCI UK index’s corporate profits are earned outside of the UK.

The other economic overhang is the trade war which, despite occasional signs of a thaw, has generally continued to escalate over recent quarters. We are still a long way from the US and China agreeing a wide-ranging trade agreement. Moreover, the US government has now begun to impose tariffs on European goods in response to a World Trade Organization investigation on aircraft parts. Although most analyses suggest that the intensification of trade tensions may have a significant but manageable impact on the global economy the International Monetary Fund (IMF) estimates -0.75% from real global growth of approximately 4% next year), in reality, simulating the spill-over effects from further rounds of protectionism into business confidence and asset prices/ wealth effects is likely to have a wide error band. Events could easily gather momentum. Our assessment of broad equity market valuations would suggest that in capturing economic sensitivity, the market is disproportionately focusing on the “risk” in the value part of the market. Valuations elsewhere in the market look increasingly exposed.