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Market Commentary

Of Russia, Versailles, and cheap UK equities

By August 4, 2016No Comments

Whether your investment choices make any money, and how much, will be driven by a mix of valuation and confidence.  

Russian equities are an extreme example.  They are ridiculously cheap, at a 50% discount to global emerging markets which are themselves cheap.  Even though it is possible to identify companies that have performed exceptionally well in sanction-constrained Russia, this is certainly not reflected in their share prices.  And that is all about confidence.

If Russia is an extreme example on one side of the argument, it can be argued that the US is at the other end. Based on long term valuation measures (such as CAPE, cyclically adjusted price earnings ratio) the US stock market has been hitting new highs and is now back to valuation extremes which have been seen less than 10% of the time in history, and this when profits are spluttering.  This is based on (a kind of) confidence – on the one hand that there is no alternative, and on the other that the central bank “has our back”.

UK confidence? Those who think the Brexit vote can be overturned or ignored are like “bedraggled courtiers fleeing Versailles after the French Revolution, they are unable to process the reversal that has occurred” (New Statesman).

This includes a chunk of the media (e.g. the FT?) and clever City folk, for whom to be confident would be to admit the “reversal”.  This small but influential group continue to undermine wider confidence, which they also refuse to acknowledge.  [Perhaps it would be fairer to say that this “wider confidence” is more of a shrug of the shoulders]

UK stock market valuations are fine (25% below the median since 1969, according to the FT, surprisingly), and better value than France and Germany. But according to some City folk (and the FT) this is not cheap enough, and a recession needs to be priced in.  Yet real people running real businesses and consuming goods and services are largely not fazed.

For example, there has been record buying by directors of FTSE 100 and 250 companies; housebuilder Taylor Wimpey just announced trading is “in line with normal seasonal patterns”; a good number of CEOs running the dynamic smaller companies which a sister company researches are saying it’s “business as usual”.

For that recession to occur business owners and consumers need to change their behaviour. The shock of the Brexit vote has not obviously changed the behaviour of either across the board – in contrast, the Lehman shock in 2008 did change behaviour overnight, which is why it was such a dangerous time.

Absent a large scale Lehman-style event (which could spring from anywhere in the world) a recession of consequence would only arise from a persistent fall in confidence over time. Carney and Downing Street get that.That’s why so many positive stories have already been planted about countries ex-EU being enthusiastic to develop UK trade links – not much substance of course, not yet, but the authorities understand the need for positive narratives in the next 2-3 years. That’s also why there will be more substance in the months ahead.

Firstly, from the Bank of England (not just a rate cut), and then up to and including the Autumn Statement in November take your pick from tax cuts, infrastructure spending, more QE (buying corporate bonds), further encouragement for bank lending, cuts in Stamp Duty, and more initiatives for first time buyers.

With any luck these measures will lay a foundation for UK share prices to advance, particularly in those sectors where there is already obvious good value (see Further Reading below).  Although over shorter periods the UK stock market will always be in thrall to global events, financial and otherwise, look out for even cheaper buying opportunities in UK equities when there are bumps in the market road.

Dennehy Wealth