Surrendering to fortune, last year’s review of the London market suggested a few negative scenarios for 2017. Destabilising Brexit talks, faster-than-expected interest rate rises, and the oil cartel failing to see through its cuts to production. But a fourth and less severe option was also posed – that commodity prices would hold their gains, with Brent crude continuing its resurgence, and the UK economy would muddle through.
The more benign option turned out to be closest to the truth. Although UK stocks did not keep up with their US cousins, perhaps due to the political outlook, they saw a broader-based recovery than in the previous year. That left the same, but intensified, questions confronting investors as we head into 2018. Given the high price that ebullient markets are putting on future profits, is it time to take some risk off the table? Should a grim fiscal outlook from the country’s official forecasters encourage shareholders to turn negative on UK plc?
First, the numbers. The FTSE All-Share managed a total return, with dividends reinvested, of 8 per cent between the start of the year and 1 December, compared with 11 per cent in the same period last year. Investors care about real returns, of course, and it is worth noting that inflation is strengthening, in part due to sterling weakness. In the November figures, the most recent at the time of writing, the consumer prices index was running at 3.1 per cent, the highest for six years. That takes a chunk out of your investment return, but it is still beating the long-term average by a good margin. UK equities managed a real total return of 5.5 per cent between 1900 and 2016, according to this year’s edition of the Credit Suisse Global Investment Returns Yearbook.
If 2017 did not reach the peaks of 2016, the performance was at least more evenly shared. According to Datastream figures, 61 per cent of stocks within the FTSE All-Share index managed to beat the average return, compared with 35 per cent in last year’s review. Whereas the mining sub-sectors more than doubled in value in 2016, this year they had to settle for two digits rather than three when it came to percentage growth. There was also strong performance from the electronics and software and services sectors – the rise of cyber crime helped security specialist Sophos (SPH) double in value over the period.
Know thy index
The major financial services sectors all rose in value, despite some concern over the domestic economy. “What continues to set London apart, and justifies its claim to be the world’s leading international financial centre, is the global, cross-border nature of much of its business,” say the Credit Suisse report’s authors, pointing to the City’s pre-eminence in banking, fund management and other financial services.
Besides the political implications of the statement, it is interesting in that it is true, and in what it could tell us about future performance. There is widespread anxiety about valuations in the equity markets of the world’s more developed economies, but it is worth pointing out that not all indices are created equal. Nor do they necessarily develop in the same way as each other.
Take the FTSE All-Share, which captures 98 per cent of the UK’s market capitalisation from around 638 companies. Compare that with the S&P 500, which captures 80 per cent of the available market cap listed stateside.
Data gleaned from Thomson Reuters Datastream tell us that a decade ago, the 10 biggest companies on the market – a familiar group of banks, miners, pharmas and drillers – accounted for 38 per cent of the market cap. Ten years (including a global financial crisis) later, a similar group of names account for 35 per cent.
Compared with London’s familiarity, the US index has changed markedly. In 2007, the top 10 companies accounted for a fifth of market cap, and were made up of storied names including conglomerate General Electric (US:GE), consumer goods seller Procter & Gamble (US:PG), and telco AT&T (US:T).
Although the top stocks’ proportion of the overall market cap is broadly unchanged, the leaderboard has had a major tech makeover, with Apple (US:AAPL), Amazon (US:AMZN), Facebook (US:FB), and Google, or more precisely, its parent Alphabet (US:GOOGL), joining Microsoft (US:MSFT) in the top 10.
Take the newcomers and add in video streaming service Netflix (US:NFLX) and you have the so-called ‘FAANG’ stocks, about which market commentators are getting increasingly queasy. Information technology companies in aggregate account for 24 per cent of the market, according to S&P data, and some market commentators see the momentum of these stocks as representing another tech bubble.
There are some grounds to think the London market should not share all of America’s pain in the event of the tech bubble bursting. In the financial crash, centred on multinational banks, the two markets had more in common. But the growth of our more modestly sized software and services sector does provide some pause for thought.
Calling the top
Taking a wider view, some market commentators see the same forces behind currently stretched valuations in both markets, regardless of the type of company: net investment inflows into market-cap-weighted strategies. The bigger companies are getting automatic bids from exchange traded fund providers, who track them simply because of their size: cap-weighted funds hold stocks in proportion to their weighting in the index.
This is feeding disquiet about a momentum effect that could reverse if those net inflows were to turn into net outflows. “This particular distortion is the largest in history,” Steven Bregman, co-founder of US investment adviser Horizon Kinetics, told me earlier this year.
In an interview with our sister title, the Financial Times, earlier this month, star fund manager Neil Woodford saw doom ahead: “Investors have forgotten about risk and this is playing out in inflated asset prices and inflated valuations,” he argued. Mr Woodford thinks investors are making the “same mistakes” as they did before the dot-com bubble.
The FTSE All-Share and the S&P 500 are both trading in advance of 22 times current earnings. In our 25 August issue, the ‘Anatomy of a crash’ cover feature re-ran a tweaked version of the forecasting model of Martin Zweig, who famously predicted Black Monday. It issued its ‘sell’ signal, as my colleague Algy Hall wrote, for the first time in a decade. Coupled with tightening monetary policy and the high valuations on equity and debt, there are plenty of bad signs for those looking. And there are some places to hide, as Megan Boxall examined in last week’s cover feature (‘Crash-proof your portfolio’, IC, 8 December 2017).
Considering the short positions, the London market’s best guess on what will go wrong in 2018 are not too much different from its best guesses a year ago. Still, the grocers J Sainsbury (SBRY) and WM Morrison (MRW) and, despite its recent boost, Ocado (OCDO), remain among the most popular targets for short-sellers. The general anxiety around the near-term prospects and long-term disruption of general retailers sees Debenhams (DEB) and Marks & Spencer (MKS) near the top of the hit list, too.
Aside from the vagaries of investor sentiment, one could venture that the progress of UK equities in 2018 will rest on how bad things get at home, and how good they get abroad. The official forecasts, baked into the rather grim autumn Budget, are taking a cautious view of the growth of the domestic economy. It is too gloomy for those such as Mr Woodford, who has made a contrarian bet on the recovery of domestic retail and banks.
There may be profits for optimists. It is not hard to argue for a recovery in a banking sector trading in line with its book value, at a time when interest rates are just starting to rise, employment is high and the post-crash, clean-up job is at last approaching a conclusion. Against that, we have concerns about a further squeeze for the consumer economy from rising prices, and Brexit talks speeding towards the March 2019 deadline.
Ex-UK, many forecast growth rates are being revised upwards, with factories at home and abroad buzzing to meet the demand from a buoyant global economy. The purchasing managers’ index for eurozone manufacturing registered 60.1 (anything above 50 means expansion), the second-highest monthly reading in the survey’s history, while UK manufacturers registered 58.2, the highest since 2013. Sustained global growth will lift all boats.
Crunch coming?
The counter argument to those foreseeing a tech-led crash is that the market is merely reflecting the changing world. Amazon is your retailer, Blue Prism is your workforce, Netflix is your TV. If this wave cannot be rolled back, then the constancy of London’s largest players could betray a weakness, unless they are able to innovate successfully.
It has not always proved wise to bet on incumbents, but it has been a year where Glencore (GLEN) rebranded itself as the future-proof miner as electric cars proliferate. Insurers such as Aviva (AV.) have been pouring money into digital ventures, including robo-adviser Wealthify, in which it announced taking a majority stake in October. And it has been three years since fund manager Schroders (SDC) made an investment in rival Nutmeg. Steps are being taken to support earnings for the long term, but Provident Financial (PFG) provides a cautionary example of how difficult it is to change horses midstream.
Brexit is the big unknown. It could be disastrous for companies selling into, and sourcing from, continental Europe. Or shared interests may prevail in the talks. Whether or not the market is too bearish on the near-term prospects of the economy is today’s debate. As is whether valuations are quite high enough to trim or exit positions this year-end. For the IC reader, I suspect, the view will be longer term, and whether companies are fit for the increasingly digital economy.
