A degree of volatility returned to UK equity markets at the start of 2018, albeit briefly, before the benchmark indices returned to the relative calm that we witnessed throughout much of 2017. Things became a little more febrile towards the end of September, although you’re left with the suspicion that these corrections – assuming that’s the appropriate designation – were essentially ripple effects from across the Atlantic.
People tend to get a little too excited whenever there’s a shake-out in the market; after all, a study by Credit Suisse shows that it took only seven trading days for the CBOE VIX index to revert to the mean following the February sell-off. But it’s probably worth noting that in several instances when a spike in volatility followed a period in which stock markets had been becalmed, such as 2004-06, they have heralded index highs. We will obviously have to wait for the outcome on that score, but it is possible to draw some conclusions about relative valuations.
Corporate earnings and institutional outflows
The UK has historically offered attractive risk-adjusted returns from companies representing a broad range of sectors, and yet the growth in UK equity valuations has been relatively subdued, certainly by comparison to that of the US. But the reasons for this aren’t always bound up with company earnings – far from it apparently.
According to The Share Centre’s latest Profit Watch UK report, which collated the most recent quarterly and half-year results from FTSE 100 and FTSE 250 companies, profits from UK blue-chips and mid-caps have hit a new all-time high, rising to £218bn in the 12 months through to November. The report highlights a 13.7 per cent increase in pre-tax profit though the third quarter, while revenues have risen for nine consecutive quarters, the longest period of expansion in the aftermath of the financial crisis.
It hasn’t all been plain sailing; several high-street retailers have taken a beating, while banking profits have been constrained by increased litigation costs and legacy issues. And the profit surge is somewhat lopsided, with the outperformance restricted to the largest 40 companies analysed in the report.
Nevertheless, the findings are certainly at odds with several forecasts that were doing the rounds this time last year. Swiss investment bank UBS thought that UK profits were being artificially bolstered by sterling weakness, both in “transactional” terms, or through the “translation effect”. In other words, the pound’s post-referendum decline had given way to more competitive exports and foreign exchange benefits for UK companies with high levels of overseas earnings; slightly ironic given that both Royal Dutch Shell (RDSB) and BP (BP.) have been driving their quarterly earnings on the back of resurgent crude prices. Brent Crude averaged $75 a barrel during the July-September period, up from $52 for the same quarter in 2017.
External factors still hold sway
And yet UK equities remain unloved, a reminder that markets can’t exist in isolation, hermetically sealed and immune to external levers. The point probably seems obvious 10 years on from what Lord Rothschild described as the “greatest monetary policy experiment in history”. But government intervention can take many forms and, if anything, the effect of outside influences on UK equities has probably intensified over the past year, with fundamental analysis still taking a back seat – hardly an ideal scenario for an investment magazine you would imagine.
This time last year we highlighted the most likely determinants for UK equity indices, namely the Brexit effect, the prospect of “faster-than-expected interest rate rises” and whether Opec members and Russia would continue to act in concert to regulate crude prices. You obviously didn’t need to be Mother Shipton to work that one out, but short of any resolution on these issues, it’s clear they’re still driving the narrative as we exit 2018 – Brexit, chief among them.
The drawn-out nature of the negotiations and lingering uncertainties over the UK’s future trading arrangements with the European Union (EU) are still weighing on UK equity valuations, with capital outflows mounting as we move towards the March 2019 deadline. UK stocks have underperformed against other major developed markets this year – not surprising given capital allocations. Figures from the Investment Association show that over £10bn has been pulled from UK equity funds since the 2016 referendum, while around £12.8bn has been allocated to UK bond funds over the same period – that’s a risk-off trade if ever there was one.
Adjusted earnings and FCF
At the time of the EU referendum, the FTSE 100 was registering a forecast price/earnings (PE) multiple of 17.2, with a forecast yield of 4.1 per cent, against respective comparisons of 18.0 and 2.2 per cent for the S&P 500. The rating was significantly in advance of the CAC 40, Dax 30, or even the perennially frothy Nasdaq Composite. Fast forward two-and-a-half years and the UK benchmark, despite solid growth in underlying earnings, is registering a forward PE ratio of 12.1, with a forecast yield of 4.9 per cent, against 16.4 and 2.1 per cent for the S&P 500.
We can dig a little deeper by appraising the ratio between an index’s current price and its average inflation-adjusted earnings over the past 10 years or so – the CAPE ratio. German asset management firm and research house Star Capital has been publishing its own CAPE score value rankings since 2007. Its October figures have the UK on a CAPE of 15.5 (against a long-run average of 15.8) – cheaper than Germany (18), France (20.1), the US (29.4), India (20.8), Australia (17.8) and even Italy (16.1). Going further, and creating a composite value score based on a basket of measures including CAPE, PE, price-to-book and aggregate dividend yield, the Star Capital team rates the UK as the 16th cheapest out of 40 developed and emerging equity markets.
Another useful value indicator is projected free cash flow (FCF) yield: the level of cash flow a business generates for its owners, divided by market cap, specifically the FCF per share a company is expected to earn against its market value per share. On this basis, the investment case for the FTSE 100 has also become more compelling — with the measure rising from 4.4 per cent in June 2016 to 6.2 per cent today.
Political risk clouds valuations
The widening disparity between UK equity valuations and those for our main trading partners doesn’t amount to an oversight on the part of fund managers – markets abhor a vacuum, uncertainty. There is an outside chance that the UK may leave the EU with no deal in place, but the long-term implications arising from an abrupt exit from the bloc are difficult to quantify, although we can only assume there will be near-term disruption to various supply chains, together with unforeseen complications arising from non-tariff barriers. The increasing instability of Theresa May’s government means there is also a risk for investors of a general election being called with the possibility of a Corbyn government. Such an outcome might be viewed by some fund managers as a more negative scenario than the prospect of a so-called ‘hard Brexit’. There is a mitigating perspective in that you could argue that many of the UK benchmark constituents would be better placed to see out any initial problems because over 60 per cent of FTSE 100 profits are generated outside the UK.
If you disregard the political dimension, it’s difficult to square the relative performance of UK equities against external risk indicators. Figures from the Office for National Statistics (ONS) certainly suggest that overseas investors haven’t deserted the UK as an investment destination, with the value of the UK’s foreign direct investment increasing by 12.6 per cent to £1.34bn in 2017 when compared with the previous year.
Attractive valuations can be found across the UK market, and the suspicion is that a wholly unsatisfactory political settlement will follow in the wake of our existing scheduled departure from the EU (assuming the March deadline holds firm), but one that will provide a degree of certainty where equity markets are concerned. If that does transpire, it seems likely that the UK equity market – and underlying valuations – will benefit from a restoration of institutional inflows. However, the fact remains that even if UK equities appear relatively inexpensive when set against many foreign markets, any judgement needs to be set against the duration of the bull run. If we are seeing signs of a general unwinding – and the signs are there – there is some good news for investors. UK equities have not recovered to the same extent as the US since the financial crisis, so a general pullback will present buying opportunities for investors on the lookout for mispriced assets.
UK equities: relative values, external levers
The UK economy - Trouble ahead
Must politics always weigh on European stocks?
Japan: Abe's arrows still on target
US equities: losing their bite
Emerging markets and the Trump effect
FX: Too early to call the top of the dollar rally?
Brexit: Businesses scramble to adapt
Asset Allocation: Favouring durability and defensiveness
What fund managers expect in 2019
Resources: Calling time on fossil fuels?
Housebuilders set for a squeeze
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