The UK market is starting to move lower, down now 8.5% from the May FTSE 100 highs @ 7900. Year to date the FTSE is down 6% with the mid cap FTSE 250 index down 5.35%. Whether we are seeing the 10 year bull market for shares (post credit crisis) finally exhausting itself, time will tell. Perhaps we are just experiencing a healthy correction in prices, pre-empting the formation of a potential bubble in the equity asset class; bubbles ultimately tend to burst. Of more genuine concern might be the ongoing monetary tightening by the US Federal Reserve which has now raised interest rates three times this year to 2.25%, signalling potentially 3 more rises next year. By comparison, base rates in the UK are at 0.5%. The bull market in shares both at home and across the Atlantic has had record low interest rates at its core. Investors have been drawn to shares (paying higher dividend yields) as a preferred (if riskier) home for funds. Now bank savings accounts are starting to pay more as are fixed interest bonds (as prices fall) by way of yields, share prices theoretically also need to correct (by prices falling) to maintain their relative allure. Equity markets tend to ride on the back of bond markets my old boss used to say.
The level of the US equity market for some causes most anxiety for valuations here are way in excess of other geographic areas (for example in Europe or the Emerging Markets). Moreover US indices have barely fallen from their highs as investors have continued to embrace the positive economic data relating to growth and employment. The Fed clearly feels rates need to be higher to risk manage current conditions and at the same time, keep inflationary pressures in check. The Fed is not however responsible for the level of the stock market. They are mandated to set monetary policy at an appropriate level in accordance with their assessment of US macroeconomic conditions. If ultimately this brings about a corrective move in asset prices, so be it. Their actions bring heightened risk to investors without doubt. Also if inflation does not really move higher (which the Fed expects) and rates have been moved higher still, growth is vulnerable to being extinguished, perhaps in a stagflatory environment. US equity markets would certainly look too high if that type of scenario were to materialise.
Closer to home, Brexit talks have reached a critical juncture and the political landscape is uncertain at best. This reality doesn’t particular assist with the mood. If a weak pound continues to be a product of this situation, one positive is that it inflates the international earnings of many companies.
On balance some clarity relating to our forward relationship with Europe will likely be a net positive for the market in my view as will knowing who our Prime Minister is likely to be at least for the foreseeable future.
The relative strength of the dollar and the ongoing hawkish language from the Fed is keeping the Emerging Markets under pressure. Many EM companies have issued dollar denominated bonds (debt) which post FX translation will be costing high sums in interest payments. EM currencies of course remain relative weak. A 20% slump in Chinese markets since the beginning of the year currently shows little sign of improvement also, fuelled further by the anxiety being caused by tariffs, trade war nerves and a strained dialogue with the Trump administration. China is the world’s second largest economy and not to be underestimated in its importance in the global economic machine. Clearly another risk variable therefore in projecting the next direction for markets.
Market bears talking bear markets suggest that equities are now (over) due a period of underperformance and at its most negative, that an economic slowdown or recession is a possibility over the next few years. The bears have been banging this drum though already for a number of years. Should such a recession take hold, it would most likely need to a global phenomenon and one would then expect to see a period of falling share prices, reflective of falling corporate profits. I suspect this outcome to be unlikely. Even if global growth were to weaken, I suggest as more likely is that some form of corrective move lower in equity markets is probable if not already underway (not that we have seen anything yet by way of material falls in the US). So a re-pricing of risk.
As an advisory stockbroker, I will try and actively allocate funds (for clients) according to my views of the world and market. This might allow for a level of cash balance to be held indefinitely and for certain geographies, sectors and individual stocks to be invested in (or not) at any one point in time. This differentiates for example from the passive manager who will likely be fully invested at all times. In terms of my current outlook and beliefs, I would mention the following:
I am inclined to prefer companies which have relatively well protected cashflows and earnings as they will likely perform better in the event of a market set back or economic slowdown. In this area, tobacco stocks and / or pharmaceutical options might be possible area to consider.
Importantly (but not always), more defensive options also tend to pay attractive levels of income (by way of dividend). While an investor may not have income as a core objective, a yield can help insulate against downside on a share price on the basis that (assuming a dividend is secure), the share theoretically should not fall significantly beyond a certain level. This as opposed to a more highly rated growth share that pays little (if anything) by way of income yield.
There are numerous examples of UK listed shares that have been very consistent (stellar even) performers over the past 5 years (plus) but now sit at high valuations (PE ratios or multiples to profits). With the significant appreciations in prices to date, yields have fallen to new buyers of these stocks bringing little byway of the aforementioned yield support. These areas thus look potentially vulnerable to some weakness certainly if economic growth projections come into question. It could also be argued at the simplistic level, that valuations in these areas look up with events in any case.
I have been investing in these shares. A 20% fall in the price since mid-August has brought about a much improved entry level at 212p. Issues within the Asia focused businesses have clouded significant ongoing progress in the core UK business where recovery momentum remains. Margins and profits are rising here funding growing dividends again with net debt significantly reduced. The acquisition of Booker and the current roll out of discount proposition Jacks are drivers of future growth. I am hopeful that the shares offer relatively well insulated growth potential (if in the retail area)with the shares trading at around 14.5 times this year’s earnings and yielding a growing 2.4%.
Gold is interesting me now as it has underperformed most other asset classes for an extended period having reached $1920 per ounce back in 2011. Currently it is $1185 per ounce and trading near year lows and not far from 2 year lows. Often supported in times of market anxiety,this precious metal may now be (more than ever) a contrarian option ahead of any future market upsets or economic slowdowns. Not a guaranteed hedge against market turbulence, it is often bought for its not correlated asset potential in portfolios. Ways to gain an exposure might be through ETFs, managed collective investments (such as the Black Rock World Mining Investment Trust) or gold mining company shares (for example the FTSE 100 listed Randgold Resources).
This report was written by Philip Scott, Director at SI Capital on 9/10/18 when the FTSE 100 index was trading at 7230.
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