12 Jun 2019
UK Equities | June 2019
“Party like it’s 1999”, “Let’s all meet up in the year 2000”, “Back to the future!” … there are no shortage of cultural touchstones we can reach for as we consider current equity markets. Since the jitters of late 2018 we have seen a resurgence in demand for defensive growth. In the US this has principally meant Big Tech, but in the UK we have seen mega-cap commodity stocks take their place at the top of investors’ buy lists and dominate market leadership.
Although there are also echoes of the famous “Nifty Fifty” period of the early 1970s, we are more drawn to the parallels with the era referenced by the songs of Prince and Pulp. In weighing up where we stand in a late-cycle global economy, we can’t help recalling that market dynamic where stocks seen as “old economy” are discarded in favour of those considered “new economy”.
As the left-hand graph in Figure 1 shows, high yielding stocks across Europe and the UK (here a proxy for the “old economy”) have only been cheaper once during the past 30 years. The fact this one occasion was in 1999/2000 resonates with us given the present-day parallels with that period.
At the turn of the century the global market’s appetite for growth also saw investors draw a line between stocks which represented the ex-growth, tepid “old economy” and the dynamic, disruptive “new economy” led by stocks predominantly belonging to the TMT (telecommunications, media and technology) sectors.
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Source: LH: Factset/Morgan Stanley, MSCI Europe, 30 April 2019. RH: 1 Numis Securities, Topdown Charts, Jay R Ritter, March 2018. 2 Bloomberg, 31 March 2019.
If that chart suggests the “old economy” is once more being neglected, the right-hand graph tells us that the “new economy” has returned to levels of animal spirits also seen two decades ago – for new US IPOs (here a proxy for the “new economy”) it appears a case of the more negative your earnings, the better! This year, just as back then, a dovish pivot from the Federal Reserve following successive hikes sent a signal to markets that low rates and cheap borrowing could be here to stay. And while the music’s still playing most people take the view that, in the words of another Prince, this time former Citigroup CEO Charles “Chuck” Prince, “you’ve got to get up and dance” – that’s even if more than four of every five companies coming to market is loss-making?
Precisely how close we are to the moment when the music stops is a contentious subject. There are many who think the next cut from the Fed will spur another leg of growth, as seen in its dovish response to the LCTM1 and the Asia crisis of 1998. This intervention culminated in a melt-up in the tech bubble. In assessing the present day we believe we could be an hour closer to midnight than many would like to believe. An accommodative Fed may have kept the party going in 1999, but sowed the seeds for a painful hangover in 2000 with “old economy” stocks benefitting from a dramatic rotation out of tech and growth.
The left-hand chart in Figure 2 shows that last month the S&P “growth” versus “value” premium surpassed its 2000 peak. The right-hand chart, meanwhile, shows the “Buffet Indicator” which measures total US market cap as a percentage of US GDP. This can also be seen returning to levels last reached 19-20 years ago. We would argue these are two more indications that the elastic has become very stretched.
Source: Bloomberg and Columbia Threadneedle Investments, as at 30 April 2019.
In this we are not seeking to call the end of the current cycle, rather we hope this adds some context to our caution on the sustainability of the current consensus positioning. Could we be due a downturn reminiscent of the early 2000s where the US economic recession was relatively mild, but equity market rotation out of the “growth” basket was violent?
We think the proliferation of passive and exchange-traded fund money in the market these days will only amplify the severity of any such event, given the “valve”-like quality of passive fund positioning (money rushes in at speed … but try rushing out!). In the meantime, some naysayers are folding as the pressure of taking the opposing side intensifies up to the point of reversal – voluntarily or otherwise.
In the UK, where Big Tech is largely absent, just like in 1998/99 we have seen “quality growth” stocks enjoy a further rerating as “value” names have been spurned. Interestingly, oil and mining stocks have been lumped in with the quality defensives because of their current cash generation post-strong commodity price rises – ignoring the risk of future cyclicality. It is from this narrow range of names that the market leadership of recent months has come (underpinned by momentum-seeking passive flows).
The large part of the UK market which is neither domestically exposed nor commodity-driven has been largely left behind, despite counting many proven international franchises among its number. The weight of money that has exited the UK market, due to the political and economic uncertainty brought about by the Brexit maelstrom, has opened up a large price differential between those companies listed in the UK and their peers listed overseas.
In fact, valuations of the UK market relative to the MSCI World Index show it has not been this cheap versus the rest of the world for 30 years (and has only been cheaper once over the past 40 years)2 – a discount we would say is highly disproportionate to reality.
This is an important area of value and has created opportunities for active managers – as has the blanket derating of “old economy” stocks thought to be doomed to declining growth, or worse, by “new economy” disruptors. We acknowledge that some of these companies have big structural issues, but should they really be priced for extinction? In our view the answer is not black and white, but in fact grey. Instead, we would ask whether the market has punished a share price without giving due consideration to the resilience of the business or its ability to adapt.
With the elastic once again becoming very stretched we think that, just as in the early 2000s, a marked rotation from growth into value is overdue. Our aim is not to predict the timing or the indeed the trigger, but to ensure our portfolios are best prepared to weather the turbulence and seize the opportunities when that moment arrives.
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1 Collapse of investment firm Long-Term Capital Management in 1998.
2 Bloomberg, 1 June 2019
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