Crisis averted? Don't bet on it over the medium to long term

one-investor-under-umbrella-one-investor-getting-rained-on

On 10 January 1979 the Sun newspaper borrowed the title of a 1975 album by the British band Supertramp for its front-page headline.

'Crisis? What Crisis?' was the Sun's acid-tipped response to prime minister Jim Callaghan, who, on returning to strike-bound Britain from a summit in Guadeloupe, faced calls for his Labour government to declare a state of emergency.

He told reporters: 'I promise, if you look at it from the outside, I don't think other people in the world would share the view that there is mounting chaos.'

However, widespread industrial unrest in response to Labour's attempt to control inflation by imposing a 5 per cent cap on wage increases for public sector workers quickly spread to other sectors of the economy in the 'Winter of Discontent'.

CONFIDENCE HIGH

It spelt the end of the Labour government: in late March Callaghan's government lost a motion of no confidence by one vote, and Margaret Thatcher's Conservatives swept to power.

I am reminded of that Sun headline (often wrongly attributed to Callaghan himself) when assessing the state of the UK economy and stock market today. The initial post-Brexit vote blues have been well and truly consigned to the dustbin.

The myriad calamitous forecasts that came to be known as 'Project Fear' - the attempt by the establishment-led Remain camp to scare the bejesus out of voters and maintain the status quo - have clearly failed to materialise.

House prices are buoyant: in September the Royal Institute of Chartered Surveyors confirmed reports from mortgage lenders that buyer confidence is returning, with a net balance of 12 per cent of respondents reporting an increase in prices in August, up from 5 per cent in July.

Manufacturing has received a fillip from the post-Brexit fall in sterling: the manufacturing purchasing managers index saw its biggest ever monthly bounce: up from 48.3 in July to 53.3 in August (a reading of more than 50 indicates expansion, and vice versa).

Retail sales have also largely defied expectations: although falling 0.9 per cent year-on-year in August (Olympics-weary consumers were perhaps too tired to go shopping), they were up nearly 2 per cent on the month before.

Most important for investors has been the reaction of the stock market. Even the domestically focused FTSE 250 is currently at an all-time high - at 18100 (as at 9 September), it is 21 per cent up from its 27 June nadir.

Smaller companies, as measured by the FTSE Small Cap index, have since gained 16 per cent, on a par with the rise from the FTSE 100. The more internationally focused index remains at a multi-month high of around 6900 and within striking distance of the 7103 high point it reached last April.

What's not to like? It begs the question, in the absence of any material evidence of crisis, whether it was necessary for the Bank of England (BoE) to halve interest rates to 0.25 per cent in August and indicate that a further cut may be necessary this year.

Given the current seemingly happy state of affairs against the backdrop of Mark Carney's projections of looming Brexit-induced recession, the cover image of Supertramp's album would likely strike a chord with the BoE governor.

In the background there is a grim industrial and housing landscape, while in the foreground we see a skimpily attired pale male in sunglasses basking in the sun with what looks like a bottle of Malibu rum on his table.

MEDIUM-TERM THREAT

Appearing before a Commons select committee, Carney himself declared that he was 'absolutely serene' about the forecasts and judgements that the Monetary Policy Committee had taken in the lead up to the referendum, and he left the door open to further cuts in rates, perhaps in the autumn.

However, at the risk of sounding like the proverbial broken record, the current level of the UK stock market has little to do with strong economic or corporate fundamental attractions.

bond-yield-comparison-between-two-tounsand-and-six-and-currentlyIt more reflects the falling value of the pound, an ever-rising sea of liquidity - courtesy of central bank largesse - and a search for yield by income hungry investors who can't find it in the cash and bond markets.

Markets have also clearly priced in the fact that Brexit, in whichever form it takes, is a long way off. Negotiations have not even begun with our erstwhile EU partners, but it's possible to get a flavour of what is to come.

Both the US and Australia have been bluntly honest when it comes to the process of setting up new trade deals: the UK can get in line behind more important trading partners, such as the EU itself.

On the shape of the UK's future relationship with the EU, prime minister Theresa May is keen not to rule anything out. Yet it seems the cabinet is at odds over what shape that relationship should take.

David Davis, the minister for exiting the EU, was slapped down when he told parliament that 'if a requirement of membership is giving up control of our borders, I think that makes membership of the single market very improbable'.

Ignoring the implications of Brexit might sustain the market in the short term, but for most investors it is the medium term that counts.

So private investors need to answer this question honestly: does the rebound in the UK stock market - particularly outside of the FTSE 100 - support UK plc's medium-term prospects outside of the EU?

UK equity fund managers are fairly unanimous in their assessment: they don't know, don't care or maintain that it is not as important as the quality of companies in which they invest (see below).

However, a quick glance at some valuation measures confirms that there is value to be found in medium-sized and smaller companies. The FTSE 100, in contrast, looks overvalued on some important measures.

For example, the historic price/earnings (p/e) ratio for the Footsie has reached a whopping 39.9 times, and dividend cover is only 0.59 times earnings, which suggests that maintaining - let alone growing - the current level of dividend payments will be increasingly difficult.

In comparison, the FTSE 250 index's historic p/e ratio is 20.9 (dividend cover 1.92 times) and the FTSE Small Cap (excluding investment companies) index's p/e is 18.5 (dividend cover 1.82 times).

YIELDS AT RISK

Another worrying observation to make in the hunt for yield is that the FTSE 350 Higher Yield index, which comprises 126 high dividend-paying stocks, is looking ominously overbought. The historic yield of 4.8 per cent on this index is superior to that of the FTSE 100, which yields 3.6 per cent.

Yet the historic p/e ratio for the Higher Yield index is 51.5 times earnings and the dividend cover is just 0.4 times last year's earnings.

footsie-index-performance

Despite earnings upgrades for many companies as a result of sterling weakness after the Brexit vote, something, eventually, has to give here. In the absence of meaningful corporate profit growth, it will be share prices that will bear the brunt.

These fundamental pointers to the current value (or otherwise) of UK-listed shares are also reflected in market performance in the year to 9 September.

According to data from Numis Securities, the total return from the Higher Yield index has been 17.5 per cent, compared with 13.5 per cent from the FTSE 100, 8.4 per cent from the FTSE Small Cap (ex investment companies) index and 5.8 per cent from the FTSE 250.

The conclusion to be drawn is that any Brexit-inspired crisis for UK stocks is probably some way off, so smaller and mid-sized UK firms have scope for a further rerating. But investors seeking income will increasingly need to be very selective in their choices if they are to avoid a Callaghan-esque downfall.

WHAT UK EQUITY RATED FUND MANAGERS SAY

Adrian Frost and Nick Shenton, Artemis Income: We have, for the most part, resisted the temptation to buy the UK domestic stocks that were going cheap after the Brexit vote. Instead, we prefer to spend our time identifying those businesses with the best long-term prospects.

Nick Train, CF Lindsell Train UK Equity: Of course prices and expectations are all over the place after the initial explosion of post-Brexit vote market action.

Investors assume something important has changed, but they are not clear what, or what the ramifications are. In contrast, we assume nothing of any importance has changed. This could be wrong, of course, but it means we haven't engaged in any frenzied portfolio rebalancing.

David Horner and David Taylor, MI Chelverton UK Equity Income: It is too early to relate any feedback on the 'real' effects of Brexit - no one currently knows.

What is important to the corporate sector, however, is that there is no liquidity crisis, balance sheets remain generally strong and a period of two years after Article 50 is invoked should at least support some sort of status quo.

Gervais Williams and Martin Turner, Diverse Income Trust: It is assumed that smaller companies will be vulnerable to a UK slowdown, but many companies have overseas exposure. We believe the ongoing dividend growth of the portfolio will drive longer-term capital performance.

Charles Montanaro, Montanaro UK Income: Whatever happens over coming months (in the US election, for example), the opportunity to invest in businesses with demonstrable earnings growth will continue to exist, no matter what the environment.

Note: quotes derived from fund factsheets produced in August.


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