A Change in the Markets

Friday, 20th January 2017 09:09 - by David Harbage

This week’s economic news indicates that the UK economy is performing well, and certainly a lot better than many supposed-experts had predicted back in June when Brexit was being contemplated. Unemployment fell by 52,000, in the three months ending 30 November 2016, to 1.6m claimants – a level not seen for over a decade.

More critically, one would have to go back to the twentieth century to see a 4.8% rate (or proportion of the capable, known as economically active, population) of unemployment. Particularly impressive if one thinks of the growth in the domestic population over the past twenty years, evidenced in the number of full time employees (23.25m, up 209,000) and part time workers (up to 8.55m, a rise of 86,000) in the same quarter period. The Office of National Statistics (ONS) also advised that average earnings had risen 2.7% (2.8% if bonuses are included) over the past year.

The UK equity market has been fixated on the worth of sterling over the course of the past six months, effectively showing a strong negative correlation: when the pound has weakened, the FTSE100 index (in particular) has risen to reflect the translational impact of companies’ overseas profits being enhanced. This view has been reinforced, emotionally if not intellectually, by a presumption that the domestic economy was set to be a weak performer compared to its peers. As it turns out, this has not proven to be the case, with the UK growing its gross domestic product (GDP: total of all services and goods produced) by 2% in the year just ended; better than any other leading G7 (an informal bloc of the world’s leading democracies: Canada, France, Germany, Italy, Japan, the UK and the United States which, incidentally, is likely to have grown 1.6% in 2016) nation.

The source of such data is the Washington, US-based International Monetary Fund (IMF) and they predict that growth in Britain’s GDP will be 1.5% in the current year – in-line with Germany, but ahead of the other major continental European economies of France and Italy (forecast to grow by 1.3% and 0.7% respectively). This backdrop no doubt made it easier for Prime Minister, Mrs Teresa May to make her political speech outlining a little more of her government’s plan to leave the European Union (essentially Brexit), and also to face business leaders on the same subject, this week. However, from a stock market perspective – and a UK equity one in particular – it raises at least a couple of interesting issues.

In the first instance, it challenges the natural assumption that the FTSE100 will be principally driven by the relative worth and direction of sterling. And, secondly, investors may have to reassess the notion that domestic earnings are likely to be secondary (in pace of growth, if not quality) to those arising overseas. Consensual thinking, on the magnitude of the dispersion of likely return in 2017 and beyond, may have to be revisited. It could be that sterling’s significant strength (appreciating by almost three US cents) on the day that the prime minister advised that Brexit would mean leaving the single market, could have reflected foreign exchange trading positions (“better to travel than arrive”) rather than fundamentals.

However, a currency’s relative worth is historically driven by ‘carry’ (the rate of interest on offer) as compared to that paid by what might be deemed the alternative currencies – think US dollar and the Euro – as well as by the anticipated health of its economy (versus peers). In addition, foreign exchange commentators will also point to inflation as being a prime driver of central bank interest rates ( a rise in the latter expecting to inhibit the former); subject also to overall confidence in the underlying economy. In the case of the United Kingdom, domestic inflation appears set to rise further in 2017 - from the 1.6% annual rate of the CPI (being the Consumer Prices index) announced by the ONS for December 2016. This was the highest pace of inflation since July 2014 and, of course, much of it is attributable to the weakness in the pound since the EU Referendum result.

Whether interest rates rise, per the historical precedent, later this year remains to be seen. This writer has his doubts on how much the Bank of England will move rates beyond 1% (from the current 0.25%), because real GDP remains below the longer term (say 25 year) trend. Equity investors may wish to consider the prospect that sterling is close to reaching a point of relative stability – if not necessarily a low point – against the world’s major currencies. As such the ‘knee jerk’ benefit of sterling weakness may be over and normal service might be resumed in terms of looking at fundamentals. This is said against the backdrop of the beginning of the company reporting season, with the US trading quarterlies typically being first off the mark. The prospect of a Trump administration reducing taxes (boosts profits), spending more on infrastructure and incentivising US companies to invest at home has provided a boost to the dollar and to Wall Street. Whether these hopes are realised may determine the short term outlook for US equities (which must, to some extent, impact our stock market as well), but this observer would expect investors in the United States to pause for breath after last year’s remarkable strength which has left valuations looking stretched. 

Domestic investors may be wise to reassess the mix of their portfolio by reference to domestic and overseas earnings. Current historic (based on the last full disclosed year’s trading) valuations show big US dollar-biased earning businesses like tobacco manufacturer BAT Industries on a 35% premium to the wider UK equity market, on a PE of 22x – albeit anticipated profit growth of 18%, 15% and 7% in 2016, 2017 and 2018 will bring that price/earnings multiple down to a more reasonable 15 times. By contrast, domestic companies often bear a neglected appearance: like the Midlands pub operator Marston’s (best known for Wolverhampton & Dudley and Banks beer) which is on a single digit earnings multiple, even though profit forecasts for 2016 have barely changed over the past year. Such businesses could be the beneficiaries of rising consumer confidence and spend – in this case, eating and drinking out more – and the 35% discount to the market’s average earnings multiple (PE of 9x is anticipated in Marston’s year to 30 September 2018) may recede.         

Usually, a reduction in uncertainty represents a positive for risk assets and markets – although there are undoubtedly more unknowns surrounding the UK economy as the Brexit ‘roadmap’ proceeds, which will take several years to play out. Fear may have contributed to some strong directional winds in 2016 (notably in currency terms and the appetite for non-£ earners), a partial reversal seems likely in the early part of 2017 – if only driven by share valuations amongst many of the FTSE100’s constituents reaching unappealing levels.

Premium rated companies may appear just that (a quality business, where investors have high expectations, meriting an above average market worth), until a profit warning removes the premium, as seen at international publishing giant Pearson- whose shares fell from £8+ to under £6 this week on the announcement of a disappointing trading statement. By contrast, domestic bookmaker Ladbrokes Coral announced better than expected trading this week which prompted a 10% rise in their share price. Unlike the FTSE100 media stock, the recently merged FTSE250 betting group is set to benefit from broker upgrades for  this year and calendar 2018’s profits, with 14p EPS (earnings per share) anticipated by the consensus of 20 brokers that follow the group. This would put the shares on an undemanding PE of 9x and with an additional attraction of a (twice covered by forecast profits) dividend yield of 5.4%.            

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.