Two months on - the fog may be lifting

Wednesday, 6th February 2019 08:38 - by David Harbage

The author last blogged two months ago and flagged the geo-political concerns which were depressing investor sentiment at the time, as well as proscribing common sense ‘medicine’ prompted by forty years’ experience of financial markets. What has changed since the beginning of December to encourage an easing in fear and encourage investors to increase their appetite for risk assets? To answer that question, let’s revisit the previous blog – whose title, ‘The short view…..’ indicated a focus on current issues, whilst mindful that most readers will be private individuals with the longer term perspective appropriate to investors in company shares - and highlight any changes with additional comment.

“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.” Political machinations surrounding Brexit have continued but, notwithstanding the majority of parliamentarians being against a ‘no deal’ exit, the outlook remains equally uncertain – with no compromise or progress being made on the controversial Irish ‘backstop’ issue. Mildly bullish for markets as the worst case scenario – effectively involving the greatest degree of uncertainty – recedes.

“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.”  Inter-party talks to find a solution to the Brexit issue indicates a softer, less polarised tone which has been welcomed by public opinion – with opinion polls showing an increase in support for the Conservative party (up 5% to 41% in the past month) and an easing in an ‘anti-political establishment or ‘populist’ vote (Labour down 7% to 34%). Media talk of a snap election in June 2019, which prevailed at the end of January, has subsided. Bullish, as domestic worst case political possibility has eased.     

“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.” No change: the possibility of a clear mandate to remain in the EU, be it via a second referendum or general election, is no closer or distant – with politicians fearful of an unpredictable ‘backlash’ from a general public, who will feel ignored. But the prospect of a deferral of the exit date may be welcomed by the market based on a ‘no pain yet’ view and a belief that negative momentum could result in a very soft exit or a ‘remain by default position as the populace will become increasingly dispassionate about the subject. No real change, as we are no closer to determining the actual outcome of Brexit (or not).      

“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.” There is growing evidence of a domestic slowdown, both by consumers in their spending habits (despite evidence of real wage growth in the latter half of 2018) and by the corporate sector (inventory build, ahead of a potential ‘no deal’ Brexit, has not compensated for a slowdown in investment). This could result in a short term boost to profits - as capital expenditure is restrained – with the consensus earnings growth forecast in 2019 for listed companies set to rise (from 8%), at the same time as economists predict a small improvement in GDP (from 1.4% to 1.5%). The stock market’s ancient saying that ‘travelling can be better than arriving’ (typically pronounced in expectation of a positive development) could also be applied to anticipation of a negative event – even one as unpredictable as Brexit. We are undoubtedly closer to the pivotal moment, but have probably past the point of deepest fear.  

“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.”

Encouraged by better than forecast trading announcements amongst domestic stocks which had been aggressively marked down in the second half of 2018, there has been evidence of persistent net buying – from both institutional and retail sources – in January and February to date. This has been accompanied by a pick-up in sterling’s relative worth (versus the US dollar and the Euro) pointing to a shift in asset allocators’ views on UK equity and credit – with a number of prominent commentators suggesting that a bounce-back was probable from oversold valuation levels. Supportive rationale featured a view that Brexit would be determined by the summer of 2019 and, as a consequence, the UK (including the £ and its equity) would be perceived in a more favourable light. The turn of the calendar year would seem to have marked a change in investor sentiment towards the UK and its assets.

“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.”

Most investors would prefer to see real evidence of a change before making a financial commitment, but history shows that the biggest gains go to the bravest who ‘bottom-fish’ when the prospects look most gloomy. Buying quality assets, whose valuation has seemingly been depressed without sufficient reason, makes sense – but the majority of serious investors may await encouragement in the form of trading news before taking action. The shares of oil giant, BP, which have rallied by 5% since their low point in January, added a further 5% today in response to analyst-beating figures covering the final quarter of 2018 and a positive forward-looking statement. Long term investment, via regular savings, makes eminent sense as it can be the means of accumulating good assets at attractive valuations.

“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.”  

It will be interesting to see how robust dividend pay-outs are in the current reporting season – which has just commenced – against the backdrop of some firms having little visibility on future revenue and profits, given the Brexit-induced uncertainty. Last year represented (another) record year of quoted companies’ dividend payments and this writer is confident that distributions will be hiked again in 2019. By contrast UK interest rates are unlikely to rise by much more than 0.25%, the ten year risk-free interest rate (the yield of British Government stocks, held to redemption) is currently just under 1.3% and inflation appears to be easing, rather than accelerating. The income attraction of owning company shares (ideally via a diversified portfolio of dividend payers) remains intact, relative to the prime alternative sources of income.

“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.” In looking at a number of individual companies, as well as the overall market, in the first five weeks of 2019, it is interesting to note the relatively low volume of shares that have been traded. This might seem counter-intuitive, given the market’s pronounced move, but essentially reflects the fact that the majority of big investing institutions retain – rather than actively trade – their company holdings. As encouraged by the likes of Warren Buffet, overtrading, most evident at times of higher market volatility, tends to detract rather than add value; retaining assets in which one has strong conviction is likely to deliver a more satisfactory return to shareholders.    

“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.”

Medium and smaller size domestic businesses tend to be capable of producing higher growth (facilitated by their flexibility), as well as also being likely to possess less dominant leadership within their industry and may feature weaker balance sheets, than the largest multinational firms. Returns from the FTSE250 index and the FTSE Small Cap index have tended to outperform the FTSE100 over the longer term but, when returns are negative (as in 2018), they typically underperform. Hence the need for diversification in the smaller company arena in particular, using the likes of collective investments if not owning sufficient individual businesses across different sectors of industry. Any recovery in UK company shares in 2019 is likely to be led by smaller – rather than larger – companies, especially if the catalyst is a resolution to Brexit. If, as a consequence, demand for sterling picks up, then the multinational business may suffer an adverse translation impact (when non-£ earnings are accounted for in pound terms).    

“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), come to mind. 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.”

Over the past two months, each of the above mentioned stocks have made progress – but only after falling further before beginning their recovery: Lloyds Banking Group +5.5% (from 55p, down to 50p on 27 December, up to 58p today), Legal & General +8.5% (from 244p, down to 223p on 27 December, up to 265p today) and Persimmon +23% (from 1893p, down to 1859p on 17 December, up to 2430p today), benefiting from a positive trading update in mid-January. A similar, if less dramatic, picture can be seen when looking at the performance of the pooled vehicles over the past two months: Aberforth Smaller Companies investment trust +1.5% (from 1216p, down to 1120p on 17 December, up to 1236p today), Henderson Smaller Companies investment trust +6.5% (from 780p, down to 730p on 7 December, up to 830p today) and, finally, Mercantile investment trust +4% (from 187p, down to 168p on 27 December, up to 195p today). Co-incidentally the largest individual position within each of those trusts is a domestic residential property developer, namely Urban & Civic in the Aberforth trust and Bellway in both the Henderson and JP Morgan managed trusts.  

“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.”

The prime concerns surrounding global events – the pace and magnitude of rate hikes in the United States and, perhaps more critically, the prospect for US-China trade tariffs – appear to be easing. Although financial markets have rightly been perturbed by President Trump’s efforts to influence the Fed’s policy on interest rates, the central bank’s chairman has indicated that a pause in the tightening cycle is appropriate. Ahead of the 2020 Presidential elections, Trump is likely to seek some form of a trade agreement with China and, as the instigator of the so-called trade wars (notably the imposition of higher tariffs), he will be able to lay claim to some ‘progress’ in his ‘America First’ campaign. The heightened trade tensions of the past year have contributed to a slowing of growth in global GDP – with Europe in particular a ‘flat spot’, based on the most recent survey evidence; this, in turn, could contribute to lower interest rates and inflation for longer which can underpin equity valuations. Evidence of a less confrontational, more amenable US President in 2019 would represent a positive for global risk assets, but the only political certainty would seem to be the likelihood of further surprises. While economic growth appears unexciting in the developed world (featuring typical GDP of between 1.4% and 2%), financial markets would prefer a year of fewer external shocks to prompt a sustainable bounce-back from 2018’s weak showing. Historically, on balance, the UK equity market has tended to advance in seven out of every ten years – but delivered negative total returns in three of those years. Closer examination shows no positive co-relation between stock market performance and the pace of economic activity; indeed, equity has tended to perform better when GDP growth has been below the longer term trend rate and, perhaps unsurprisingly, after a poor previous year. The latter could give cause for optimism amongst investors in UK company shares but, accompanied by a near absence of economic ‘feel good’ news, it will be important to hold one’s nerve and retain a focus on the long term and the relative valuation merits of real assets.

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.