A new prime minister, an opportunity to review

Wednesday, 24th July 2019 14:43 - by David Harbage

Yesterday, the Conservative party’s new leader was announced and today Boris Johnson becomes prime minister. Love him or loathe him, this colourful character is set to move financial markets as he seeks to break the Brexit impasse which has persuaded so many asset allocators to avoid investment in sterling based bonds or equities. Reviewing one’s portfolio should be an ongoing exercise, even for ‘buy & hold’ long term personal investors in the stock market, and if the reader has been lax in this regard, this change in political leadership prompts an opportunity to consider what the next few months might have in store for investors.


The new prime minister and his cabinet will be focusing on trying to persuade the EU to change the terms of the previously agreed - but widely disliked - Withdrawal agreement. While fresh personnel and impetus should not be disregarded, the prospect of seeing sufficient change on key areas, like trade across the Irish border (the infamous ‘backstop’) is slim. More likely, Mr Johnson will have to call a General Election – to gain the necessary votes in Parliament - as the means of achieving (a ‘No Deal’) Brexit before the 31 October deadline. The new Brexiteer controlled government will ignore calls for a second referendum; politically, an early election to capture the Boris enthusiasm and depressed popularity of a Jeremy Corbyn-led Labour party would seem opportune.


Predicting political contests has proven hazardous in recent times – here, in continental Europe and ‘across the pond’ – and another UK election would be no less difficult to call. Rightly or wrongly, Brexit would be the overwhelming single issue (polarising opinion a la the European Parliament election earlier in the year), with a rise in tactical voting undoubtedly playing no small part. Under proportional representation (which applied at the EU polls), uncertainty would almost certainly prevail as a coalition of minority parties would emerge. However, the ‘first past the post’ system provides the possibility of seeing a conclusion – one way or the other – as the ‘leavers’ vote for sympathetic Conservative or Brexit candidates, and ‘remainers’ elect Green, Liberal or more probably Labour MPs.


Beyond the Brexit issue, incidentally, investors in UK listed company shares should be fearful if they anticipate that the current left wing-leaning (anti-business, higher taxation) Labour party can pull itself out of its current weak state – that is, if they can produce a clear strategy on Brexit (expect Congress to come down conclusively in favour of a Second Referendum, if not a clear Remain in the EU stance), convincingly resolve the anti-Semitism issue and, ideally, elect a new leader – to win a majority and form the next Government. The reality of a Labour administration might not be as bad as the markets would anticipate, but the knee-jerk reaction would be painfully negative on sterling, government stocks, bonds and equities.


Resolving Brexit would end the uncertainty and, even allowing for inevitable EU trade dislocation pain on a worse-case ‘No Deal’ scenario, the UK equity market would regain its poise and be able to look forward with greater certainty on critical issues like business investment than currently prevails. Professional fund managers are beginning to anticipate the easing of uncertainty and to purchase domestic company shares which have fallen dramatically over the past three years to the point at which their valuation, relative to the overall UK equity market or to overseas markets, has reached a 30 year low.


As an example of this dispersion in company valuation, relative to prospects, within the UK equity market consider Unilever, the £59bn market capitalised Anglo-Dutch food and household product manufacturer – whose shares have risen by more than 25% in 2019 to date. Currently, the shares of this global leader are valued on a heady price-to-earnings (PE) multiple of 23.8 times its last trading results, offers a 2.7% dividend income yield and, according to broker consensus forecasts, is set to increase earnings per share (EPS) by 7.9% in the current calendar year and by 10.0% in 2020. By contrast, the overall UK equity market (or median company share) valuation and profit forecasts are an altogether more appealing: PE of 12.4x, a dividend yield of 3.9% and EPS growth of 11.3% in 2019. 


Illustrating recent activity of institutional investors, James Anderson the manager of Law Debenture investment trust (which announced half year results today) has been switching from global (and US in particular) equities into UK company shares since May of this year. In addition, Sue Noffke, who heads up UK Equities at Schroders, has been moving from UK listed multinational businesses towards more domestic stocks within the Schroder Income Growth investment trust portfolio that she manages. As regular readers of this blog will know, the writer has a clear focus on Value (and Growth At Reasonable Price – known as GARP – in particular), so would agree that many domestic firms appear to offer exceptional value.   


Putting Brexit to one side, what else should investors be considering in the second half of 2019 and beyond? The focus of global investors has been on trade wars – typically prompted by President Trump’s efforts to close the United States’ deficit with the likes of China. This has had a ‘headwind’ effect on economic activity, which the Federal Reserve Bank has recently acknowledged - and prompted a reversal in fiscal policy. The prospect of rate cuts in the US, and easing by other central banks, makes the income offered by equity and fixed coupon bond investment more attractive – but investors in company shares should be mindful of any reduction in profits, leading to pressure on dividends, which could result from a global slowdown.


Yesterday, the International Monetary Fund (IMF) issued an update to its forecasts for growth in gross domestic product (GDP) around the world – easing back its previous prediction of real (after inflation is taken into account) global economic growth to 3.2% in the current year and 3.5% in calendar 2020. So, while clearly on a slowing path, this is not recession – although a number of major economic blocs or countries (think Eurozone) might be getting close to this experience of negative economic growth for two successive quarter periods.


Besides the perennial issue of profit projections, another area that has been exercising the minds of financial market strategists has been a rise in geo-political tensions. While Iran may be taking ‘centre stage’ (with the free traffic of oil tankers in the straits of Hormuz being at risk) in this regard, today’s media has highlighted concerns surrounding predatory behaviour elsewhere (notably from China and Russia impacting South Korea and Australia).


Allied to the diminishing income returns from Cash, investors might consider the merits of that traditional ‘store of value’ in difficult political times: gold, or the businesses which extract and own precious minerals. Historically, the ‘greenback’ is also seen as a safe haven, but the prospect of falling interest rates may restrain risk-averse investors’ appetite for the US dollar. In addition, other central banks’ appetite to stimulate their economies by printing more paper currency – seen most obviously a decade ago in the banking or financial crisis – could also be a catalyst towards persuading individuals to own real, physical assets.


In recent years, non-financial demand (notably from Asian consumers, in India and China in particular) has exceeded new supply of gold, and the recent rebound in the price (to US$1,425 per ounce currently) could continue further – if not reach the US$1,917 high achieved in August 2011. Tracking Exchange Traded Commodity (ETC) funds, such as the i shares Physical Gold ETC or the Invesco Physical Gold ETC, could represent a means of capturing the gold price – but prospective investors should pay close attention to such funds’ potential use of financial derivatives, (as opposed to owning the physical assets), in pursuit of their objectives. 


An investment in individual gold mining companies has historically been a higher risk-reward equity investment, as predicting future production from what is often geologically testing conditions - and, in geographical terms, their location is often in business-unfriendly regions of the world - is challenging. The price or valuation placed on producers will logically rise or fall by a greater extent than the price of the commodity – making them a geared play on the price of gold, silver or other mineral. However, the reality is that often the share prices of gold miners have not matched the metal price - as individual company (or mine) and country (or currency) circumstance has been the prime factor influencing or determining valuation.


Fully listed (as opposed to AIM, the Alternative Investment Market) and profitable precious metal mining companies are rare on the London stock market – FTSE100 constituent Fresnillo, the world’s biggest producer of silver and Mexico’s second largest gold miner -  probably being the best known. As one might expect, the stock price has been volatile, falling from £20 three years ago to 773p at the time of writing – reflecting production concerns, most recently. An investment in a diversified collective fund, such as the US$11bn VanEck Vector Gold Miners Exchange Traded Fund (ETF) which seeks to own the world’s largest gold miners might represent a more reliable means of owning the producers.     


While possessing an unashamed preference for Value and income producing assets (which, of course, physical Gold does not possess, although the extractors may pay dividends), one Growth area of interest is technology. Be it the internet or in bio-health research, technology is changing the world – it is to be hoped for the better – and Wall Street listed giants like Amazon, Alphabet (which owns Google and YouTube) and Apple have changed the way consumers and businesses operate, typical dislocating traditional paths and means. In the considered opinion of this writer, while many of these technology giants are likely to only increase their influence and wealth over the longer term, the immediate stock exchange valuation of their equity typically appears fully valued.


By contrast, smaller technology companies would seem to represent a more attractive investment opportunity for the long term investor. And, in the shorter term, Herald investment trust might possess additional appeal, as its £1bn portfolio of stock exchange quoted businesses – investee firms which normally have a maximum market value of US$2bn - has a bias to the UK. The current geographic breakdown reveals: 51% UK, 19% US, with between 1% and 3% in each of South Korea, Israel, China, Canada, Australia, France, Taiwan and Norway. To date in 2019, five UK companies have benefitted from overseas predators (who view the sterling priced firms as relatively inexpensive). Katie Potts has been managing this portfolio of (currently 270) technology, media-related and telecommunications (TMT) businesses for the last 25 years and has consistently delivered strong absolute and relative returns.


Nevertheless, perhaps some negative sentiment surrounds the domestic bias or the acknowledges the higher risk profile of this industry segment, as the shares are currently priced at an 18.4% discount to the net asset value of the underlying investments. This higher than normal (looking back at the average, over the past five years) discount would seem anomalous given the performance of the portfolio, but could tighten on any resolution in Brexit (notwithstanding a rise in sterling should the UK remain in the EU) to provide a short term benefit.                  

The final investment which current market conditions might suggest – of slowing top-line (revenue or turnover) and profit growth – features a focus on another exceptional factor, which might increasingly capture investors, as well as public interest: that of climate change. The utilities sector, featuring essential services such as electricity and water companies, is one of the most reliable in terms of its income flow – although often subject to government regulation of its pricing and capital expenditure (with consequent reduced control of its profitability).


Often perceived as dull or uninteresting, this segment of listed equity investment could attract more investor attention if other areas of business are overvalued or are experiencing a slowdown in their growth. The prospect of discovering and progressing renewable energy and employing environmentally-friendly processes in business is perhaps most possible in the utility industry. A London stock exchange listed fund which appears neglected, by reference to its equity valuation (share price) as compared to the underlying worth of its assets caught the writer’s attention.


Ecofin Global Utilities & Infrastructure trust owns £140m of assets – based 41% USA, 41% continental Europe, 13% UK, 5% Emerging markets - which currently produce an income yield of 4.5%. Incidentally, Mr Corbyn has spoken of a future Labour government re-nationalising domestic utilities (the FTSE100 stock SSE Group is a constituent of this fund). More interestingly, 20% of this fund’s assets are in renewable energy investments, 21% in regulated utilities, 15% in transportation (includes Bejing airport) and 44% in integrated businesses. The shares are currently priced at an attractive 13% discount to the net asset value (NAV) of the underlying investments. Managed by Jean-Hugues de Lamaze, the trust has an impressive track record of outperforming both UK and global indices.         


In summary then, this article seeks to anticipate what might occur in financial markets – and the UK equity market in particular – in the second half of 2019, post the appointment of the unorthodox politician Boris Johnson as prime minister. Likely to be less conventional than his predecessor or his opponent in the party leadership contest, raised emotive forces are likely to impact risk assets more obviously in coming months. However, such higher volatility (or turbulent pricing) could be ‘a price worth paying’ if the prospect of Brexit being resolved (one way or another) represents the ‘prize’. Such an outcome is likely to be positive for UK equities, and especially domestic stocks (from their current depressed, relative to peers) valuation. Meantime, a slowing global economy and a more dangerous or unpredictable geo-political landscape persuades for consideration of traditional safe haven assets and stock exchange investments featuring more resilient earnings.


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.


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