01 Dec 2017
Mark Barnett
Head of UK Equities
Invesco Perpetual
As an investor in a global stock market such as the UK’s FTSE All-Share Index, I am acutely interested in the various aspects of the macroeconomic environment. In an increasingly globalised market, interest rates, economic trends and politics interweave and interact to influence on markets.
My interest in these macro drivers is academic to an extent: as a stock picker I am ultimately interested in the financial performance of the companies I own and how that will shape their path to sustainable dividend growth. While the economic cycle can make a difference to the smoothness of that path, it does not have to be the defining factor to performance over the long term, particularly for medium-sized companies or niche players who can grow organically by winning market share, sometimes capitalising on the ups and downs of the economic cycle along the way.
However, I feel we have reached inflection points across a number of global macro and political fronts; high valuations in certain sectors, shifting monetary policy and geopolitical volatility have the potential to recalibrate the status quo across a number of sectors.
While stock markets have enjoyed a pretty smooth ride since the 2012 Eurozone crisis, the macro risk now seems to me to be very much to the downside, with the exception of the perceived Brexit risk to the UK economy.
The significant underperformance of sterling-based investments (Figure 1) and the sharp decline in the currency supports a view that Brexit is an accident waiting to happen for the UK economy.
This bearish view is not my central scenario. Brexit brings with it all the uncertainties that politics can throw up, but I believe it is highly unlikely that the negotiating process will end in stalemate. Even now, at the height of the uncertainty, the UK economy is performing robustly.
Indeed, the short-term price for the Brexit vote has almost been paid in full, in that the spike in inflation that eroded real consumer spending power has played out and is about to reverse.
A key risk now to investors in the UK stock market is a material recovery in sterling and a violent rotation away from the international earnings that dominate the FTSE 100 index, into domestic-facing companies currently trading on recession-type valuations. Sterling assets are now undervalued on a risk-adjusted basis and I have increased investments in domestic companies in my portfolios.
Figure 1: Domestic stocks have underperformed exporters dramatically
Source: Morgan Stanley as at 11 October 2017. Bespoke baskets of UK-listed companies composed by Morgan Stanley.
The ‘normalisation’ of monetary policy and the return to positive real interest rates looks set to gather pace. This has implications for valuations in many parts of the market, which I think have been inflated by the consequences of super low interest rates. Although there are structural causes of low price and wage inflation, I now feel that bond markets could sell off even within that paradigm.
I do not find it bullish that the US Federal Reserve is openly declaring itself perplexed over the relationship between unemployment, wages and prices. The Bank of England is being similarly coy about committing itself to further rate rises whilst Brexit uncertainty persists. What we can say is that 10-year bond yields at or below the rate of inflation worldwide in these economies are probably unsustainable unless we are heading for an economic downturn.
Politics in most key democracies cannot survive another recession without a total re-think of fiscal policy and how to protect the interests and income of the labour market. A re-run of the post 2008 QE policies would not be welcomed by those voters who associate it with growing wealth inequalities.
In aggregate, the rising prominence of inter-generational issues – including elevated house prices, the exponential rise in social security and pension liabilities – and the force of populism have brought key Western governments to an inflection point. These issues are set to influence policy makers and will be critical to the Conservative government over the course of this parliament.
Against a backdrop of robust economic growth, monetary tightening in the US may not be a major problem for equities if earnings keep rising cyclically. Too many segments of this market have been boosted by the long-term growth agenda (large cap tech) and the significant level of share buybacks, however, to the extent that US corporates are now the only marginal buyers of equities. Technically, the US market now feels vulnerable to a de-rating.
Another key driver of equity markets has been the recovery in commodity prices. This has been coupled with renewed confidence that the Chinese drive for more balanced growth can be achieved.
The drive by the Xi presidency to cut back on inefficient metals production for environmental reasons raises the question of whether steel production in 2017 will continue to push higher. Housing and infrastructure are giving way to services, technology and electrification as the drivers of economic growth, an overall headwind for metals prices.
Despite my views on commodities, I am confident that oil & gas equities in the major integrated groups are on an efficiency mission and that current dividends are affordable below current oil price levels.
When it comes to ‘bond proxies’, I have become more cautious. I have sold holdings in Reckitt Benckiser and Smith & Nephew, and reduced my position in the tobacco sector. I see the US FDA plans to launch a consultation on lowering nicotine levels in combustible cigarettes and to review the future classification of non-combustible products as much an opportunity for the industry as a threat. The US remains the most affordable market for smokers globally; as prices rise in the tobacco industry, so companies are able to more than offset volumes with higher prices. This remains our investment case for now.
Pharma performance since 2015 has been a major disappointment. However, I continue to find attractive risk/reward opportunities in new and developing therapeutic areas and remain optimistic that this sector can perform – even in a weak market scenario. Share prices will continue to react to news flow on drug pipelines, but it is important to remember that the major Pharma companies are well diversified with strong cash flows and a high degree of discretion over long-term costs across areas including R&D and sales and marketing.
Sterling and UK-focused sectors and stocks are central to the future performance of my portfolios, where investments are diversified across life insurance, retail, travel, support services and a plethora of specialist financial businesses. Specialist Real Estate companies feature prominently in my portfolios: quality real estate portfolios are selling at historic discounts in REIT share prices which strikes me as an attractive entry point for the sector (figure 2).
Figure 2: Real estate discount to NAV has widened significantly
Source: Stifel, as at 30 September 2017. REIT premium/discount to NAV. For illustrative purposes only. Sector is a market cap weighted average of the 32 real estate companies on Stifel’s coverage list.
At the individual stock level, it happens that a collection of previously well-regarded companies currently held in my portfolios have seen very weak share price performance in the last two years. Provident Financial, Capita, Babcock, Next, easyJet are the most recognisable names. As a result there is a recovery element in these holdings over and above the normal market rotation potential.
The performance of the UK stock market continues to be dominated by the countervailing forces of better than expected global economic growth and ongoing UK domestic political concerns. A sense of complacency may now exist over the global growth outlook. A combination of high valuations in certain sectors, shifting monetary policy and a volatile geopolitical environment may provide a catalyst which alters this bullish global outlook.
By contrast, the market seems unwilling to look beyond the uncertainty of the Brexit negotiations when it comes to valuing sterling assets which, by historic standards, are now heavily discounted. Again, this seems unlikely to persist for long.
By proceeding cautiously, employing a well-tested investment process based on fundamental company analysis and a prudent approach to valuation, there are opportunities for profitable investment in companies with the potential to deliver a sustainable flow of dividend income in the event of more volatile market conditions.
Important information
This document is for Professional Clients only and is not for consumer use.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Past performance is not a guide to future returns.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
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Invesco Perpetual is a business name of Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.