Equities have fallen, classically riding on the back of the weakening bond market and of recent, exacerbated by US wage growth data which has accelerated the rise in bond yields. Specifically here I refer to US Treasury Bonds (UK equivalent gilts) where we see 2 year yields over 2% and the benchmark 10 year yield around 2.8%. 3% yields look plausible and a pause there seems likely.
In simple terms, this means interest rates are believed to be moving quickly higher to combat inflation in America. This represents a big macro change to the low rates, stimulus heavy environment we have been used to for 9 years since the financial crisis; an environment within which share prices have soared.
Bond prices (government and corporate) move in the polar opposite direction to interest rates (actual and perceived) as a fixed (interest) return brings much reduced appeal when returns are rising elsewhere (in in bank accounts for instance by way of savings interest). Typically equities have themselves to compensate by falling in price to likewise offer higher yields as asset prices adjust. Furthermore, equities need (ordinarily) to dividend yield in excess of bonds to compensate investors for the heightened risk taken by investing in a company’s shares over a company’s bonds: the “yield gap” refers to this typical difference. Shares constitute the risk capital of a company and can demonstrate much higher volatility if ultimately, returns can be higher through share price appreciation and the potential for increasing dividends over time. Conversely shares can fall significantly in value in comparison to a corporate bond which will hold its value better.
The 10% correction we have now experienced is as much about a forced reaction to the rise in corporate bond yields as it is the fact that share prices (especially in the US) have simply risen too far unabated. Nothing goes up in a straight line (fact) and an asset bubble was being created before the recent sell off. Actually what we have witnessed (I would say) is a healthy repricing of risk, not a catastrophe but assuming a global recession isn’t ahead instigated by interest rates rising too soon and too fast. The market may actually have done the US Fed a favour by correcting itself prior to the central bank having to take the flack for cratering the market.
All geographies have seen share price falls not just the US and UK but Japan, Europe, Asia and Emerging Markets too. Some have been more pronounced primarily as some have risen to higher relative valuations. The US and Japan would feature here.
Oil has not been immune and itself has weakened over 10% (and into correction territory) from its recent highs.
These asset price falls while making for slightly uncomfortable viewing have not been a surprise to most. Indices until recently bore all the hallmarks of running out of gas with incremental rises witnessed alongside near zero volatility (fear). In a word, the market had become complacent.
Taking a shorter term view, new buying opportunities have now emerged (more later). For medium to longer term investors, this is likely a short term bump in the road that will be ironed out over the next few months I would suspect. This view is (again) caveated: that the economic landscape is not about to change for the worst.
We are not panicking if a little rattled, holding good quality shares if out of favour for now.
Market Specific Comment
The consensus view (I believe the correct one) is that further opportunity has been created as a result of the market fall. Accordingly I list below a few large cap stock specific options worthy of current consideration. These should not be considered investment advice to non-clients, nor non suitability tested individuals. Investing against the trend is never easy but buying when others are fearful is a fulfilling mantra often cited by professional money managers.
Vodafone (201p). Shares back to one year low further to a 15% slide over the past five weeks alone. Big technical (chart support) now seen with a projected 6% income yield on the stock at this price. International mobile telephony giant currently eyeing an asset purchase in Europe potentially from Liberty Global. Company has recently updated the market and backed guidance for 2018.
Imperial Brands (2605p). Staggering fall from grace with shares now 35% down on the year high around 4000p. Price to earnings ratio now under 10 with a cash backed income yield over 7%. Last week company committed to a 10% dividend growth policy. Foreign exchange headwinds will hurt profits 2-3% this year and can kicked into second half requiring an improvement on the first half to meet expectations. Labelled a so called bond proxy, its price is on a major slide (akin to the bond market perhaps) but focusing on the fundamentals as opposed to the chart(!), this warrants a look.
Lloyds Banking Group (66.5p). UK centric lender, strong capital ratios and presumed beneficiary of rising interest rates. 7.5% decline over past 3 weeks places the stock back near technical support level with a forecast PE ratio of 9.5 and income yield of 6% plus over the next 12 months. Notwithstanding further potential PPI provisioning requirements (which have sapped cash), risk reward for the stock (sector even) favours to the upside.
Aviva (490p). Shares have returned to year lows now to a 10 Price to Earnings forward multiple and yielding a growing 5.2% income. Whilst it has lagged the performance of Asia focused Prudential, new management are positioning company well for potential large scale dividend pay-outs on back of strong earnings growth (flagged end of November 2017). Also a likely beneficiary of the rising rates outlook.
Edinburgh Investment Trust (645p). £1.27 billion market cap, out of favour collective investment now yielding over 4% with quarterly distributions. Performance over past year plagued by unfortunate exposure to Provident Financial and Capita amongst others. Invesco’s Mark Barnett and former protégé of Neil Woodford is the lead fund manager. Down 17% on the year, this offers a contrarian opportunity in the belief that performance will improve over the next twelve months. Largest holdings include BAT, BP, AstraZeneca and Legal & General.
This report was written by Philip Scott, Director at SI Capital on 13/2/18 when the FTSE 100 was trading at 7168.