The short view - Fog may get worse

Monday, 3rd December 2018 12:39 - by David Harbage

The immediate outlook for UK equity is clouded by uncertainty amid the potential for seriously negative news for businesses. Owners of stock market listed companies should always be taking the longer term view – with a minimum retention period of five years or ten years, but perhaps more probably ‘an indefinite, foreseeable future’ should be considered to be an appropriate time horizon. However, on an occasional basis (say once in a decade), a major event will present itself worthy of investors’ special attention. The current domestic political landscape, featuring Brexit and its consequences, is one such event.

On the face of it, with the parties of the Opposition and many Conservative MPs unhappy with the withdrawal proposal, the Prime Minister is unlikely to succeed when Parliament votes on December 11 to accept or reject the deal which she has negotiated to leave the European Union. Irrespective of whether or not such an outcome could prompt Mrs May to step down as leader of the Tory party, the prospect of an early general election being called in the first quarter of 2019 is rising. A disillusioned or apathetic voting public could opt for change – featuring Mr Corbyn’s business-unfriendly policies and higher taxation – which could lead to further downward pressure on UK company stocks.

Another political consequence of a change in government could (with or without a second referendum on EU membership) lead to exit plans being quietly shelved, if not immediately cancelled, and the UK effectively remaining in the European bloc. Such a volte-face would not go financially unpunished, but sterling and financial markets would rally in such a ‘fog lifting’ circumstance.

What should investors do in such significant times as these? Many, if not most, perceived dangers to the corporate sector (economic recession, war or natural disaster) turn out to be less damaging than first feared – with financial commentators acknowledging that business leaders are usually capable and flexible, intelligent enough to plan and prepare for most adverse eventualities. However, for better or worse, Brexit will undoubtedly be seen by historians as a critical point in Britain’s economic and political path – akin to other issues, such as joining the Common Market or deciding whether to scrap the £ and adopt the Eurocurrency.

Alongside sterling, the equity of domestic companies has been indiscriminately sold since the June 2016 EU referendum and this disinvestment has gathered pace over the past year. Most institutional fund managers take a global perspective in their geographic asset allocation and surveys (notably the leading Bank of America Merrill Lynch one) of their members’ actions consistently suggest that – largely because of Brexit - UK equity is one of their least favoured assets to own. As a consequence of such ‘top-down’ decision making – by economists and market strategists incidentally, rather than ‘bottom-up’ company stock pickers – big life and pension funds have been reducing their exposure to the UK and, in particular, domestically-focused listed companies. Such ‘broad brush’ selling by fund managers (whose performance relative to their peers, as well as indices, is closely monitored - typically measured and assessed on a quarterly basis) has meant that home based industries, like retail or house building, have suffered disproportionately more than the FTSE100 index’s multinationals who earn relatively little in sterling terms.

As highlighted in previous blogs, individuals who make regular investments, (known as ‘dripping’ money into the stock market), can benefit from buying assets which appear oversold. The more active or aggressive investor could also be sitting on the side lines, anticipating further turbulent, fearful conditions in foreign exchange as well as stock exchange markets before awaiting a change in sentiment at those global asset allocation meetings. An easing in the lack of visibility surrounding Brexit would represent a major step forward in changing global investors’ perspective on the UK economy, the pound and British assets. However, the possibility of a general election – bringing the prospect of political change – would mean that the ‘fog’ surrounding the outlook for the domestic economy, company earnings and investor confidence could deepen rather than lift.

The experienced long term investor might dismiss the current political drama and volatility in share prices as being a temporal phenomenon saying “Markets often climb a wall of worry”. He or she would also point to the relative valuation of equity as a cornerstone of determining its fair value. For instance, you would be urged to compare the 4% annual dividend income of UK company shares to overnight cash (0.75%) and risk-free bonds (10 year government stock currently yields 1.3% per annum). Most of the dividend pay-outs are at least twice covered by earnings, suggesting that profits would have to at least halve before dividend distributions would be cut. While share prices will always be volatile – going up or down, usually by more than the fluctuations in a company’s profits or asset worth – the income returns are considerably more stable, prized by both personal as well as institutional investors.

Many private client investors are tempted into becoming traders when they see a clear trend emerge in financial markets, but should beware the speed and magnitude of the inevitable changes in direction – noting that markets are, by nature, predictive ‘barometers’ rather than factual reading ‘thermometers’. Only with the benefit of hindsight, will we be wise and fully appreciate the extent of the risks in the various outcomes that the market is endeavouring to price. Certainly in anything beyond a worse case outcome (that would have to extend to issues beyond these shores), UK equity appears attractively valued.

Medium and smaller sized UK companies (typically outside of the FTSE350 index) will usually feature higher dependence on the domestic rather than global economy and, as such, are at greater risk or could become beneficiaries of the eventual Brexit outcome. The clear consensus short term view is that an easing in the uncertainty or ‘fog’ via a negotiated deal (which facilitated tariff-free trade) would be a major positive catalyst for equity and credit markets. An announcement of a second referendum would be taken positively by markets (in anticipation of a vote to Remain), as would adoption by Parliament next week of the current deal to leave. Both events currently appear slim possibilities, but either would mean that the fog is lifting and would reduce uncertainty if not deliver complete clarity. Incidentally, the longer term Brexit perspective might take a decade or two to fully pan out and prove itself to have economic merit (with supporters of ‘Leave’ arguing that a faster pace of growth would exist outside of the more heavily regulated Eurozone), but that is too far into the future for the market to try and assess.

Amongst company stocks to benefit from improving visibility on the UK’s political and economic future the likes of domestic bank Lloyds Banking Group, the asset manager Legal & General, Persimmon the house builder, along with investment trusts focused on British smaller companies (Aberforth and Henderson) or UK’s medium sized businesses (Mercantile). Over the past three months or so, these collective or pooled investments have seen their share prices drift – relative to the worth of their underlying portfolios of company shares – meaning that prospective investors can purchase shares in these closed-ended investment companies at more attractive discounts to their net asset value.

Finally, larger UK listed international businesses will be equally mindful of the uncertainties that their wider reach encompass; these include a slowdown in the respective paces of growth in China, the United States and the Eurozone – as well as geo-political skirmishes involving Russia-US, and tariff wars between the US and its trading partners. Most obvious in the FTSE100 index, these company stocks are more likely to be impacted (for better or worse) by global events, and while possessing less fear of the consequences of Brexit, they would not be immune from any change in UK government. 

David Harbage           

2 December 2018