UK recession now more likely than not, says Barclays

The September edition of the Barclays Wealth Signpost Monthly Investment Strategy Report reports that the global economic outlook has now improved. Recession in the UK is now a serious possibility, but Barclays Wealth maintains an overall equities overweight, expecting riskier assets to outperform on a 12-month horizon as investors and markets gradually recover.

Michael Dicks, Head of Research and Investment Strategy, Barclays Wealth, said, “Although August might not have seemed especially eventful from a global investor’s point of view, it has been pivotal for a UK investor with home bias and inadequate currency hedging – serving to demonstrate how essential it is to diversify out of the UK, and look to insure against further falls in the value of the pound.

“When it comes to the rest of the world, the sharp moves in currencies over the past month serve to demonstrate both the scale of opportunities in this asset class currently and the potentially huge costs of not hedging portfolios adequately. That is particularly important when several other asset classes – such as commodities – are no longer trending higher in the way that they were previously. Investing in commodities now requires a more sophisticated approach than merely relying on momentum trading. If the dollar appreciation also marks the beginnings of a major shift in the constellation of G10 currencies, as we suspect, then investors also need to consider how a marked dollar move would affect them, and position accordingly.”

UK economic prospects:

Economic news from the UK has grown extremely gloomy. The economy may well be contracting already. Yet inflationary pressures remain elevated.

House prices are falling at double-digit rates; the key service sector is contracting; and the labour market is now clearly weakening.

Policymakers appear to be in a quandary.

Investors could consider an outright UK equity underweight. The downturn could also be worth playing by going long in large-cap UK companies, and short mid-cap or small-cap companies.

Equities:

In the US, the valuation gap for equities, based on revised earnings expectations versus real corporate bond yields, suggests plenty of upside for the S&P 500. We remain overweight in the US.

The UK is our least-preferred equity market, and we have cut our forecasts for the FTSE 100, and gone underweight in the UK.

In Europe, valuations continue to suggest that equities should rally from current levels. But gathering clouds on the economic horizon mean equity markets are unlikely to break above their 2007 peaks before this time next year.

Following sharp falls in emerging market equities, it may well take time for emerging markets to recover. but they do look very cheap now. However, emerging markets are only for the brave, or long-term focussed, investor.

In China, valuations now look more reasonable. We have moved back from underweight to neutral on the Chinese market.

India is still not necessarily cheap. But, given that the macro picture should improve over a one-year horizon, the market should do better too. We have moved back from underweight to neutral on India.

Russia now trades at a substantial discount to the rest of the world and other emerging markets. As long as political risk decreases, Russian equities both offer diversification and hedge against the impact of higher commodity prices.

Fixed income:

Government bond markets have had two good months, as falling commodities have eased inflation fears. However, the weak growth picture means there is still some value in government bonds versus cash, especially in the US where cash rates are so low. We prefer inflation linkers.

Corporate bond markets remained depressed in August: spreads have widened still further on fears that a major financial institution could default. We still prefer the highest-rated area of the investment-grade universe, such as banks and brokers.

Commodities:

Commodity prices generally fell during August, but some of this was probably due to seasonal and one-off effects, such as the Olympics. Longer-term, constrained supply and high demand should continue to support the price of many commodities.

Although gold prices fell by around 15% in August, we are still positive on the outlook for gold over the next 12 months. Gold is a good hedge against inflation; it is useful for investors concerned about another fall in the dollar; and it is a safe haven at times of geopolitical risk.

Our analysis suggests that oil prices are still above their fundamental fair value, and so have further to fall. But, with OPEC considering supply cuts, another surge in oil is certainly a possibility.

FX:

The surge in the US dollar this month probably marks the beginning of a long, sustained and sizeable rise in the greenback – provided oil prices don’t surge again. Investors should hold a small, long-term US dollar overweight.

In contrast, the sharp fall in sterling in August is likely to mark another stop in the long, and potentially huge, fall in the value of the pound.

The Swiss franc looks cheap at the moment, and is a good way to diversify tactical calls. It is also useful as a safe haven currency.

With interest rates rising in many emerging markets, stronger currencies in Latin America and Asia look likely. Investors can get exposure to these – i.e. both rates and FX – via the likes of ELMI indices.

Real estate:

Housing markets in Spain, the UK and Ireland are really suffering – lagging the US adjustment. Investors can play the property downturn by going underweight UK equities, and shorting four of the ‘big five’ Ibex stocks.

Commercial property also has further to fall. We would avoid investing in either UK or European real estate companies until the outlook improves.

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