A recent poll of global fund managers showed UK equities to be the least popular international asset class. This unpopularity is reflected in both the marked underperformance of the UK equity market in recent years, and in valuations of UK shares. This underperformance has been most marked against the US market. Since the low point reached in the Global Financial Crisis (GFC) the US Dow Jones index has risen by around 335% compared to only 117% for the FTSE 100 – a staggering difference, far in excess of the marginally higher US economic growth rate over the period. US shares are now on dividend yields averaging 1.5%, while the global average yield is 2.5%. This compares with a nearly 4% dividend yield on the FTSE 100 and with a fifth of FTSE 100 shares offering yields of 5% or more. These UK yields are particularly notable in an environment of historically low interest rates.
As a retired investment economist and fund manager I have been operating in financial markets for over forty years. This remarkable downgrading of UK equities – both in absolute and relative terms – gets my contrarian juices flowing. This is particularly so as I have a strongly positive view of Brexit, whereas global fund managers are in general highly negative, both because of its inherent uncertainty and because they accept the “establishment” view that the UK will lose more than it gains from leaving the EU. They have bought into the same “group think” that many economists and international bodies such as the IMF and OECD are guilty of. There are of course a number of distinguished economists who support Brexit – Roger Bootle, Liam Halligan, Gerard Lyons, Patrick Minford to name a few – but these are people who have always been prepared to think “outside the box”. Within my group of ex-colleagues and investment contacts it is the ones whose success was built on doing things differently that support Brexit.
My view is that this overall negative take on Brexit has clouded the judgement of many fund managers. It has led them to resist historically attractive valuations. It has also led them to ignore positive developments in the UK, and underestimate key risks in the US and in EU. These latter two factors are covered in the following two sections.
Favourable UK Developments that are being Ignored by Investors
The UK’s drive to restore fiscal sustainability reached a critical milestone in 2017. For the first time in 17 years the budget was in current surplus (£4bn) – that is current spending was more than covered by current revenue. This means that borrowing is now only financing capital spending – economists agree that this is much more prudent than using debt to finance current spending. More recent monthly budget data show further improvement. It is clear that pressures are building to relax austerity, and further progress will be more difficult, but the UK government debt to GDP ratio is now on a downward trajectory and seems set to fall for the foreseeable future. Given the huge hole the public finances were in after the GFC this is a notable achievement – and one that stands in stark contrast to the looming US fiscal crisis discussed below.
Economists have long argued that the UK needs a more balanced economy, with higher investment, savings and exports and less focus on consumption. ‘Despite Brexit’, ONS data show that UK investment spending (public and private) has grown by 9% since Q2 2016 while household spending grew by 4% in the same period. The prime indicator of an existing imbalance was the very large and sustained current account deficit. There are again very encouraging signs of balance being restored. The current account deficit almost halved from a peak of 6.8% of GDP in Q3 2016 to 3.5% in the 4th Q of last year. Exports grew strongly in 2017, and export orders and surveys suggest continued good growth in 2018.
A key factor in this trade improvement was of course the Brexit-induced devaluation of Sterling in 2016. The Remain camp still enlists this devaluation as evidence of the malign impact of Brexit, when it was exactly what the economy needed to offset the previous overvaluation of Sterling and begin the process of re-balancing. The previous BoE Governor, Mervyn King, has written about how the Bank puzzled as to how to engineer a controlled 15% fall in Sterling and concluded it was not feasible, only for the unexpected Leave vote to produce exactly the desired outcome!
As an active investor I regularly study the balance sheets and accounts of UK companies. Over the last few years a clear pattern has emerged of UK companies cutting costs, improving cash flow, reducing debt and increasing cash holdings. Usually a company trading on a very high dividend yield is a sign that the market believes the dividend is unsustainable. I have looked at the accounts of many of the FTSE companies that trade on yields of 5% or more. In my opinion the cash flows of most of these companies are well able to sustain and indeed grow current dividends. Furthermore, many FTSE companies have improved their balance sheets so much that they have plenty of scope to increase capital investment.
With unemployment now low and widespread reports of skilled labour shortages I expect UK business investment to pick up further in coming years. A favourable final deal on Brexit would accelerate that process, but exciting developments in fields that the UK already leads in – renewable energy, aerospace, Fintech, AI, and others – will drive this process anyway. A clean Brexit will provide further opportunities in many currently depressed industries – shipping, ports and harbours, fishing, and agriculture to name a few. Global fund managers may be missing these opportunities but corporate and activist investors are not. The flow of foreign direct investment into the UK has been very strong in recent quarters, while there has been a marked pick up in merger and acquisition activity relating to UK companies.
I wrote at the top of this piece that I believe Brexit will be a long term positive for the UK economy. I don’t want to rehash all the arguments about that here, but the following is an excerpt from a letter I wrote recently to a prominent Tory MP who wants the UK to stay in the Customs Union. It provides a different angle from which to see how Brexit can boost the UK economy:
“Your campaign to stay in the/a customs union claims to be about protecting jobs. Those who are lobbying you about the need to stay in a customs union are of course the beneficiaries of the existing system. I can guarantee that they are laying it on thick in exaggerating the impact on their business of any customs changes. They will adapt to any such changes much more quickly and successfully than they currently claim.
They will be in the main large businesses, who have reached the stage of at best preserving jobs and probably destroying them, rather than creating them. Net job creation in market economies comes overwhelmingly from small and medium sized companies, companies that do not have the resources to lobby civil servants and politicians. You will not be hearing from them about the opportunities that will be provided by regulatory reform once we leave the single market and customs union. You will not hear from them about the export opportunities (or import replacement opportunities) presented by free trade deals with non-EU countries which are better suited to our economic structure than EU trade deals are. You will not be hearing from them about the opportunities opened up by reducing or abolishing EU-imposed import tariffs – tariffs often wildly inappropriate to our economy (you are far more likely to hear from those companies/farmers who are protected from fair competition BY these tariffs).
You will not be hearing from the poor people in your constituency who will benefit enormously by lower costs for food, clothing and footwear. The EU imposes nearly 2000 such taxes (that is what they are), including 104% on granulated sugar, 60% on Vietnamese shoes, 50% on NZ lamb, 12% on both women’s dresses and men’s T-shirts, 20% on orange juice and bananas, and 30% on wheat/cereals. You will not be hearing from poor farmers in developing countries (mainly Africa) who could otherwise export their produce to the UK. You will not be hearing from the many companies who do not yet exist but which will sprout up like mushrooms in a more liberated environment.
This reverts to the point about economic models. They are inherently hopeless at predicting dynamic changes. To take a pertinent example: when New Zealand was negotiating a free trade agreement with China, their Treasury model – then similar to the UK Treasury model used in Project Fear – predicted virtually no impact on NZ exports to China. It was simply too far away. In practise, NZ’s exports to China rose by a factor of TEN!
In trying to keep us in the/a customs union I sincerely believe you are erring too much in trying to preserve what is there, and are blinded to the opportunities for future prosperity and freedom that you will thus inadvertently destroy. ”
Key Risks in the EU and USA are being Underestimated by Global Investors
My first blog on this site, dated 8th March 2018, was entitled “The Euro Crisis: Forgotten but not Gone”. In it I argued that “a new Euro crisis may only be months away” and that this crisis would be precipitated by the rise of eurosceptic parties in Italy. Well, this has turned out to be one of my better predictions! This article is not the place for a detailed analysis of recent events in Italy and their implications, although perhaps the subject of a future blog. Suffice it to say that there can already be little doubt that a new Euro crisis has begun, one that profoundly threatens the future of the Euro and ultimately the EU itself. In shunning UK equities because of the perceived risks of Brexit global investors have failed to anticipate the far larger risks inherent in the long term unsustainability of the Euro.
On the other side of the Atlantic investors seem equally oblivious to another type of risk. President Trump’s aggressive trade policies are dangerous enough but I believe the real threat comes from his fiscal policy, or rather his fiscal actions as they can scarcely be called a policy. In particular the massive Trump tax cut comes at a time when:
- The US economy is in the second longest recovery in its history
- The present US budget deficit (around 3.5% of GDP) is already much larger than it should be at this stage in the cycle
- The tax cut was only agreed to by Congress in return for further large increases in discretionary federal spending, which in turn are added to by Trump’s defence build-up.
- The US has entered the time when the “baby boom” retirement wave is really getting underway and is set to massively increase non-discretionary spending (pensions, medical aid)
- The Federal Reserve has embarked on a monetary policy tightening which looks feeble in interest rate terms, but is unprecedented in terms of balance sheet shrinkage.
Markets seem beguiled by comparisons with President Reagan’s fiscal programme in the early 1980’s – which set off a period of strong economic growth and a big rally in stocks – but Trump’s stimulus is MUCH bigger and couldn’t be worse timed if it tried. US Federal debt is also MUCH bigger than when Reagan took action. The US Federal debt to GDP ratio is now over 100% compared to less than 40% in 1981 (the UK equivalent ratio is 85%, and now falling). The Reagan policy, in the face of a very tight money policy from then Fed Chairman Paul Volcker, resulted in very high ‘real’ interest rates and a much stronger Dollar. Why should Trump’s stimulus not produce the same result? Until the Fed changes course I can only see higher real interest rates and a stronger $. Of course we know that high real Dollar rates would be disastrous in a world of excessive debt, much of which is priced in US $. The Fed will therefore change course but possibly not before 2019 and not before the highly inflated US stock market has taken a pounding.
I argue that, largely because of a blind spot about Brexit, global investors are absurdly pessimistic about the UK economy and the UK share market. Even if Brexit is being badly handled, and thus turns out not to be as beneficial as Brexiteers hope, a bad outcome has already been heavily discounted by the market. In the words of renowned fund manager Neil Woodford UK domestic stocks are “discounting Armageddon”. At the same time investors are NOT discounting major risks in their favoured markets in the EU and the US. I therefore confidently predict that over the next three to five years UK stocks will provide acceptable to very good absolute returns to investors. I even more confidently predict that UK stocks will produce very good RELATIVE returns over this period. UK stocks may well still be outperformed by some emerging markets, especially in Asia, reflecting the greater growth potential in these markets. Which of course is a key reason why a clean Brexit would be so good for us.
Robert Lee May 31st, 2018 s.
P.S The possibility of a Corbyn-led government implementing extreme left wing policies will also be inhibiting investors. However, since the next election is only due in 2022, or can only take place before then if Tory MP’s vote for it, it is difficult to assess how much impact this factor is having. My own view is that Corbyn is unelectable, with the majority of his own MP’s opposed to his leadership, albeit not openly. The Labour Party should be well ahead in opinion polls given the current travails of the government but has failed to be so.