The Weekly - Limbo-dancing

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20/11/2019
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The UK equity market is somewhat in limbo at the moment as investors await the outcome of the General Election. This is typical of such a period, but we may see some volatility if the polls shift when the manifestos are published. We hope that voters are given a reasonable period of time in order for the important policies to be flushed out. We don’t want a rushed approach as occurred during the Parliamentary Brexit debate as this is the main reason why we are where we are. Parliament wasn’t given sufficient time to scrutinise the Brexit deal resulting in stalemate and hence the General Election.

All parties are releasing snippets of policies as each day goes by. So far, we have had competitive bidding on NHS spending, the timely visiting of flood zones and the planting of trees to tackle climate change, to name a few. The real crunch will be when the manifestos are published as we can then see the choices available to the voter. This is the point at which the polls could change from the current Tory double figure percentage lead. We will understand the renationalisation philosophy of the Labour Party and also the increased spending of the Tories without raising taxes, letting the deficit take the strain. Potentially the most unpopular Liberal Democrat policy to Tory voters who voted Remain will be the capping of tax-free pension lump sums at £40,000. Whether this will remain in the manifesto remains to be seen and so the polls are only currently influenced by what has been announced, which is limited, and the popularity of the individual leaders. In this department, the Prime Minister appears to be scoring well but he should not underestimate the abilities of his opposite number to connect with voters.

The markets are understandably in limbo, suppressed from direction as a hung parliament is a distinct possibility with all parties saying they won’t do any coalition deals with anyone. The value of sterling is probably the best barometer as to what the markets think is going to happen. The polls are suggesting a Tory modest majority of perhaps 20 seats with the value of sterling against the Euro now at €1.17 and against the US Dollar at $1.30, a move from lows of €1.08 and $1.21 on 9th August 2019 (Source: FE Analytics). This is a 7.5-8.5% increase in value. We would therefore suggest that a view is being taken that the polls are correct, and a Labour government majority or minority coalition is not being priced in. We have to take an investment view regardless of our own political views – what matters is what the majority of the people are likely to vote for, not what the members of our various investment committees think.

Most market commentators are suggesting a rout in the markets, a potential run on sterling and a significantly volatile event if Labour should be returned. The value of sterling and its trajectory is telling us that this is not currently being seriously considered. We have not had significant exposure to the sectors at risk of nationalisation because they have been somewhat lacklustre as businesses for some time. So, whilst the socialist mantra is that the various industries of rail, mail, electricity, water and now telecoms should be under state ownership to varying degrees, outside of telecoms, we have not viewed these potentially vulnerable industries as attractive investments for some time. Not just for political risk reasons, but because they are not that attractive from an investment perspective. A nationalisation supporter would seize on this and say that this is why they are not suitable for the private sector, but we take a view from an investor return perspective. Most grow at the pace of the population, have very forecastable earnings and dividends, are highly regulated and so finding an undervalued opportunity is difficult. They are attractive for defensive reasons if the global economy or the UK is in recession, but this is not currently our central economic expectation.

In the pursuit of opportunities, it is imperative that an investor is able to forecast the future economic environment accurately. Most importantly, this involves foreseeing a slowdown coming and taking risk off the table and the opposite, observing a benign and supportive business environment where risk taking will be rewarded. It is the latter which has prevailed over the last few years and there have been excess returns available in new technology businesses such as the likes of Facebook, Apple, Amazon, Netflix and Google, the so-called FAANGs. However, since the summer, their winning streak has come to an end with so-called growth stocks selling off, led partly by the US market’s hesitation with the flotation of WeWork, the commercial property company. US investors simply said no to what was a speculative flotation, with some management conflict thrown in where the valuation was slashed from $60bn to around $10bn. Basically, Wall Street said ‘enough’ after disappointment following the flotation of Uber and Lyft, the taxi businesses and started applying far more scrutiny to IPOs.

This has affected some of the darling funds which were exposed to these types of stocks as many also held global growth businesses such as Unilever and Diageo. Here, valuations were in excess of a price earnings ratio of 20 times earnings with the main market on 14 times which suddenly looked expensive as the environment changed. Everything similar has been somewhat de-rated although the technology laden Nasdaq and the other two US indices of the Dow Jones and S&P 500 have been reaching new highs after the lull in early October. In fact, all three have risen by 9.8%, 6.6% and 8.3% respectively since 2nd October on expectations of a US/China trade deal and improved US economic data releases which have put recession worries temporarily to bed. This bounce back in the US markets has been neutralised somewhat for the UK investor by the strength seen in sterling, the exact opposite of the FTSE-100 boost enjoyed as sterling devalued after the Brexit vote. So, if you adjust the above numbers for the move in sterling, the growth becomes 4.7%, 1.6% and 3.2%, a rather different outcome. (Source: FE Analytics)

At the same time, as the likelihood of a no-deal Brexit has reduced, which has fuelled the sterling rise, bombed out sectors which would have been most vulnerable such as housebuilders, construction and commercial property have enjoyed a recovery. This has led to many commentators suggesting that investors should be seriously considering a switch from growth investments into value and that this could be the beginning of a trend following an inflection point in September and October.

It is important not to confuse what is going on in the US technology space and what is happening in the UK with all the political influences. The UK equity market currently appears to believe that the Tories are going to achieve a workable majority and consequently ‘Get Brexit Done’ as is the party slogan. Whilst that outcome would most likely be achieved in the Commons with regard to passing the Withdrawal Agreement, all this means is that we then have just over a year, probably less with Christmas in the way, to agree a new trade agreement with the EU. This was always supposed to be the most difficult part and where the horse-trading and potential for disagreement was going to arise. We would argue that buying so-called ‘value’ stocks which have just rallied sharply in October as their worst-case scenario has been avoided for now, is not a sensible longer-term strategy. Many of the so-called opportunities are priced cheaply for reasons of structural long-term decline and have not been overlooked as the market has focused on growth and technology. They are actually value traps for the foreseeable future and there is a high likelihood that the end of the transition period will have to be extended and we return to the Brexit limbo dance after the Election limbo dance.

As we have argued before, the likes of Marks & Spencer is very unlikely to rediscover a new and highly successful business model whilst it retains a high street presence which will struggle to take back market share from on-line businesses. On the food front it is engaged in its own trade war with Waitrose which will be fought on both the high street and within home delivery as the Ocado strategy is rolled out. Either way, any business operating in a highly competitive environment with low margins and a saturated market is never going to earn so-called supernormal profits for the benefit of shareholders. Contrast this with Amazon, Apple, Google, Microsoft, Netflix and many other businesses built for our smart phones such as Facebook, Uber and PayPal, all of which are American, and you can see where the best opportunities may lie compared to so-called ‘value’ businesses which are being left behind.

So, although the likes of Unilever and Diageo have fallen by 13.5% and 14.6% respectively since 3rd September as growth shares have sold-off, 6.4% of this fall is due to the translation effect of the US Dollar earnings as sterling has risen over the period. The US Dollar has recovered a little as the economic data has stabilised and if a US/China trade deal is announced soon, this will lead to further support as further interest rate cuts from the FED become even less likely. Couple this with a resumption of EU/UK Brexit trade disagreement and a feeling of deja-vu in the UK market, then we could well see sterling retreat and growth stocks resume their appeal. (Source: FE Analytics, S&P 500)

As ever, the definition of value is based on the investor’s opinion of the quality of the underlying business and what the share price should really be. A business in secular decline should be priced at a discount to the average market valuation and similarly a business with a dominant position and a bright future at the forefront of technological innovation should be priced at a premium. Growth businesses tend to do well in economic slowdowns and during the early and mid-phase of an economic expansion. They tend to get sold-off when doubts about the economic expansion come to the fore and their premium valuation then looks too expensive based on the deteriorating outlook. As investors take risk off the table, these stocks get sold early to lock in profits. We would argue that phase has happened, whilst the world economy looks like it is stabilising. So, it is too late to sell, but there is likely to be further growth ahead as economic expansion resumes.

As for value stocks, they tend to be the weakest during an economic slowdown, but they experience a bounce when the outlook improves because they have survived the downturn revealing they are stronger than perhaps the market thought and are therefore due a re-rating. Fundamentally, however, they are most likely still a challenged business with a weak business model and unless they are in a unique turnaround situation or there is a negative sector influence which is about to change in a significant way, it is usually sensible to still be sceptical and possibly sell into the bounce if you have been unfortunate enough to hold the loss-making position.

In conclusion, therefore, we would continue to stick with quality growth businesses going forward as we foresee an improved economic environment both globally, in the US and, shall we say, a less gloomy outlook in the UK with some Brexit certainty if the polls and currency markets are proved right.

 

US Markets Edge Higher on Trade Deal Hopes

Improving investor sentiment helped lift US equity markets last week as expectations of a trade agreement between the United States and China continued to rise. Whilst no official confirmation of a ‘phase one’ announcement was made, several officials close to the negotiations stated that an agreement was close, a statement reiterated by President Trump at a speech in New York on Tuesday. Both the S&P500 (weekly gain of + 0.9%) and NASSAQ hit record highs with the expensively valued growth orientated names in the tech sector continuing to lead the market forward.

Closer to home, it was revealed that the UK economy avoided slipping into recession during the third quarter although the +1.0% annualised growth rate was amongst the slowest seen over the past decade. Subsequently, ratings agency Moody’s downgraded its outlook for the UK economy to negative with political uncertainty a significant factor behind their decision. The more domestically exposed FTSE250 closed the week largely flat whilst the overseas dominated FTSE100 (-0.8%) declined modestly. Equities on the Continent took the lead from their American counterparts edge to higher for the week whilst the Japanese Nikkei 225 posted a small loss (-0.4%) following the publication of its own disappointing economic growth data. (Source: FE Analytics)

In the commodity markets, both Brent and WTI crude both benefited from the improving trade sentiment, the former adding +1.6% to $63.30 a barrel. That was despite the monthly report from the International Energy Agency which stated that it expects supply from non-OPEC nations to rise by a further 2.3m barrels per day over the course of 2020, double their previous estimates. US production recently hit a record high of 12.8m barrels, despite the rig count falling for four consecutive weeks. OPEC hosts its biannual gathering at the start of December where it could announce an extension to its broad-based production cuts in an attempt to support the oil price. (Source: FE Analytics)

 

The week ahead

Election campaigning is likely to ramp-up this week and will dominate the media domestically, in a week that is otherwise relatively light on economic data on home soil. Sterling in particular remains sensitive to political events and UK investors will be wary of the knock-on effects given the UK’s two-speed equity market between domestic and overseas earners.

Central Banks on both sides of the Atlantic are due to publish reports; the European Central Bank is scheduled to release its latest Financial Stability Review on Wednesday, followed by the US Federal Reserve who will publish its latest monetary policy meeting minutes on the same day. With US policy seemingly finely balanced, the minutes will face close scrutiny for any clues as to the future path of US interest rates. In terms of data, a final reading of German GDP is due Friday with no change anticipated to the meagre +0.1% growth previously reported. Friday will also see a raft of Flash Purchasing Managers Index (PMI) figures due across the Eurozone to gauge business activity levels. An equivalent reading for the US manufacturing sector is also scheduled.

 

The value of an investment with Rowan Dartington may fall as well as rise. You may get back less than the amount invested.

The value of investments may fall as well as rise purely on account of exchange rate fluctuations.

Past performance is not indicative of future performance.

Source: FE Analytics (information is correct as at 18th November 2019) 

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The information contained does not constitute investment advice. It is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective investment. Opinions provided are subject to change in the future as they may be influenced by changes in regulation or market conditions. Where the opinions of third parties are offered, these may not necessarily reflect those of Rowan Dartington.