We probably spend more time reviewing the UK stock market than any other because it is the largest holding for most clients, and the UK economy drives their employment and broader financial prospects. Here is a slightly longer than usual look at the UK, the swirling risks (mostly ex-UK), and opportunities.
The FTSE 100 index has largely gone sideways since December 1999. This is not as bad as it sounds for three reasons.
Firstly, this index is perhaps more reflective of economic activity outside the UK, as it contains so many huge global businesses.
Secondly, if dividends were reinvested the outcome has been much better.
Thirdly, good funds have performed much better than this.
It is the other UK stock market index, the FTSE 250, which informs us much more on how people feel about the UK and its economy.
Immediately after the Brexit vote it was this index which took the biggest hit, unsurprisingly – in contrast, due to its global bias, the FTSE 100 was relatively unscathed. Encouragingly, it has now recovered all of that ground.
What about the upside? This is inevitably speculative, but based on experience (which I admit is very fallible in these instances) the obvious upside potential is approximately 15%.
Looking separately at valuations, according to the FT (which remains very negative post-Brexit) the UK stock market is 25% below the median since 1969. This is very encouraging – but we also need to consider the other side of the equation.
What can wrong? And how far down?
Domestically it is all about confidence.
Politics is vital here, and many analysts and economists are struggling with the idea of “political economy” (which seems to have been lost in the 19th century when the Victorian era became obsessed by analysis by numbers (and rationality), which was a slippery slope eventually leading the Queen to ask the great and good at the LSE in 2008 “why did no one see this coming?).
More or less straight after the Brexit vote the pre-May administration started dripping out positive sound bites, and this continued apace when she took the helm. The politicians are far from perfect, but they do at least understand the social mood, a skillset perhaps more important now than for a few centuries but for wartime.
Yet this is not just political fluff. Events on the ground have been encouraging too. This recently from fund managers JOHCM, who were very gloomy post-Brexit:
“the initial impact from the Brexit vote on UK economic activity appears to have been modest. Most strikingly, almost all of the consumer-focused businesses that have reported in the last few weeks have suggested that activity in consumer discretionary areas such as restaurants and pubs and general retail has been largely unchanged. More broadly, whilst business confidence has deteriorated, as seen in the initial PMI surveys, companies such as ITV have not seen a step down in advertising since the vote, whilst the likes of Segro, the logistics/warehousing property specialist, have seen companies commit to new leases. The one area that has taken a hit has been residential property, particularly in London, although this sector had already weakened in the first half of the year.”
And as I write today (27th October) the FT front page informs us “UK economy beats forecasts”, and “the UK economy has held up far better than many were expecting”.
The trick for Mrs May is to keep the pot boiling. The next big event is the Autumn Statement in November. This must not disappoint. There must be a range of initiatives with country-wide impact – be it infrastructure spending, support for the housing market or more novel initiatives.
If there is disappointment the mood might sour quickly, and the first place this will be evident is the stock market.
Looking at the FTSE 100 index, the big layer of support is 25% below where we are now. On the more domestically-focussed FTSE 250 the downside is greater still.
The Brexit vote and the idea of a real Brexit in 2-3 years has not caused the UK to roll over. But might 2-3 years of grumbling headlines do just that? Not likely. Boredom is much more likely, with not a little schadenfreude on occasion, as events on the Continent boil over every so often.
What about trade? This works both ways, and it is in the interest of nearly all parties (there is no accounting for the French) to find an acceptable balance. In any event we must remember that trade in visibles with the rest of the EU represents just 6-8%% of GDP – even in the worst case, most of that will remain in place, because people deal with people, and they like dealing with people they know. (That isn’t as glib as it sounds – academic research shows this tendency even at a time of tariffs being introduced).
What of the City? Trade “invisibles”. I have been surprised how relaxed many in the City have been on this issue, even though predominantly “Remainers”. There is a sense that although many companies might have to set up small offices as a footprint in the EU (e.g. Dublin, Paris, Frankfurt), none of these centres have the considerable infrastructure to capture very much of London’s market as a world financial centre – they would be more likely to relocate to New York. The EU needs the services of the City of London, so the argument goes, and will not want to be too draconian in its demands. We will see.
There are undoubtedly other big problems, both global including the UK and ex-UK.
Starting with markets, the US stock market remains considerably over-valued (based on the long term measure which is the cyclically adjusted price earnings ratio, or CAPE). This must not be ignored. Yet this has been the case for a number of years, and it is unclear what will finally trigger a significant bear market, or when.
Europe remains in economic doldrums and politically fragile. The political calendar is busy, starting with an Italian referendum next month, but none are likely to bring the EU edifice down.
There is one big problem at the core of Europe which could bring the world to its knees, as did the failure of Lehman Brothers in 2008 – Deutsche Bank. We will return to that one.
Chinese stability has surprised many, and Japan continues on the economic tightrope it has been on for years and benefits from a well-supported government. The rest of Asia is in decent shape, certainly relatively, and there are a good number of reform-minded governments, young populations, and inexpensive stock markets.
The ugly combination of too much debt and ageing populations is the deadly duo which we have discussed for a number of years, and which continues to cast a very dark cloud over developed economies. Negative interest rates are one of the most obvious consequences.
Rather than negative interest rates being in themselves cataclysmic, they are best regarded as the most startling example of the consequences of the unique coupling of debt and demographics.
Some believe that the central banks have run out of ammo to continue to hold the global economy together. Yet ammo has not run out, far from it. The problem is that the central banks around the world have over-egged the QE policy in the absence of any direction from elected politicians. Now the politicians are more obviously going to move to centre stage, and this will begin in the UK with the Autumn statement, as the emphasis moves from central bank monetary policy to government-led fiscal policy (AKA spending).
There are many possible policy actions, the most often mentioned being infrastructure. But the options are much richer than this. We discussed this in What is helicopter money: Part 2.
Helicopter money alone is not a solution (as touched on in the latter link). There must also be a renewed attempt to get government spending under control – we are living beyond our means and this is going to get steadily worse without concerted action. This will be painful and unpopular, so this part of the policy mix seems unlikely to happen quickly.
But in the meantime it is sensible to assume that the May regime will keep confidence in the UK simmering.
The UK stock market offers opportunities.
In recent years those buying the UK stock market have shown a preference for “Growth” companies, those with predictable profits – with lots of surplus money that had to go somewhere, this was a cautious move into the UK stocks. This left behind the shares of companies with less predictable earnings, more at the mercy of the economic cycle. These are “Value” stocks and they now look cheap, unusually so. Many of these companies also pay a decent income, which is attractive in a world of zero or negative interest rates.
Herein lies the obvious opportunity in the UK stock market which we covered off in the last TopFunds Guide – “Value” investing.
