Next week will see the release of the March factsheets for our funds. Contained within them will be a subtle, but potentially significant, change of emphasis in the message we send out. Since the back end of last year, we have increasingly raised effective investment and reduced client liquidity in the funds we run – symptomatic of a belief that the post-EU Referendum valuation discount applied to great swathes of the UK market would combine with much greater harmonization of economic growth in world’s leading economies to drive upside to equity returns.
To a large extent, that has been proven correct. On the most basic level, the share price of our UK Dynamic Fund has risen (at the time of writing) by some 27% since the lows immediately after the referendum result. Yet, as valuations started to normalise, it was difficult to say with conviction that this was anything other than a correction of valuation anomalies, rather than the basis for an expectation of a multi year run in profit and dividend growth which would push equity returns higher still. Yes, there was a material shift in profit expectations for the UK market as a whole in the second half of last year, but by far the greater part of that process was simply an arithmetical adjustment due to the weakening of Sterling.
For the majority of the post financial crisis period, the missing link that has ensured that equities remained volatile and bonds continued their extended bull run was a lack of reliability over economic – and therefore earnings – growth. In most years, earnings growth expectations would start off optimistic – and then gradually be whittled down over the course of the year in the face of one economic or political challenge or another.
Yet today, most of the world’s major economies are pointing in an upward direction. For so long the source of economic ills, the major European economies are now delivering economic growth and job creation. There is growing anecdotal evidence that the commodity dominated economies in the Pacific Rim and South America are finally turning the corner. The Chinese and Indian economies are less transparent in terms of their economic output, but secondary data looks to confirm that activity is robust. And all of this is taking place at a time when the nuts and bolts of what drives the US economy (job creation, the housing market, and domestic consumption) have maintained a trend almost five years in the making. And across the globe, inflation expectations are picking up at a time when money is still very cheap, and, in places, labour markets are very tight. This gives businesses a much greater incentive to invest now, rather than delay.
The corporate reporting season, which covers final results for the period ended December 2016, and takes place through February and March, was the most solid we have seen for some time. From our own experience, the vast majority of companies hit earnings expectations, and the small number of downgrades we saw were very much company specific. The overall trading environment has remained benign. Which has allowed the market to maintain its upwards earnings revisions trajectory, despite most of the currency related revisions having run their course. These upgrades are for real.
Which brings us back to the change next week to our factsheets. Those who have followed us for longer than they probably care to remember will be aware of the “Traffic Light” part of our macro overlay risk process. It takes five fundamental parameters (given a traffic light of red, amber or green), and depending on where they sit within their historic ranges, gives us a signal as to the “risk to capital” inherent in making equity investments at a point in time. These five parameters are based on equity PE valuations, the relationship between real bond yields and equity dividend yields, the momentum in equity earnings revisions, the market’s appetite for new equity, and straight share price momentum.
By necessity, we have had to downplay the use of these traffic lights over time, because they were designed in a period where negative real interest rates were considered extreme, and negative nominal interest rates were downright unthinkable. In that environment, a model using “normal” parameters was always likely to struggle. Yet, we have maintained the model, and still report on it monthly as we believed that historic benchmarks would prevail again.
So against this backdrop, we have seen earnings revisions truly rise on an underlying basis for the first time since 2011. This has been a long time for equity investors to face a persistent head wind. Turning to a tailwind is genuinely meaningful for prospective returns from here. This is a green light.
The appetite for new equity is also robust as the avalanche of secondary placings by private equity companies in recent times can attest to. This is a green light. Similarly, share price momentum over the last three months (our preferred time period) also flags a green light.
Which leaves us with the conundrum of valuation to address – particularly as the UK equity market feels like it has run very hard in recent times. Relative to bonds (which are still not being valued on the basis of “normal” parameters), equities still look very cheap. A green light.
Looking at valuations relative to the earnings being generated provides more of a challenge. The headline historic price/earnings ratio of the market, including exceptional items and loss making companies is indeed stretched, at almost 30 times earnings. That is a red light in our model. Yet large swathes of the earnings base of the UK market is undermined by historic exceptional write offs (particularly in banks and commodity businesses), which are not necessarily representative of the earnings base going forward. On a look through basis, the UK market is probably trading closer to 17 times historic earnings (which would make it an amber light in our traffic lights), with robust earnings growth expected in 2017 to take it down into green light territory over the course of the year.
Therefore, our March factsheets will record a shift in market phase from “Fallow Market” to “Bull Phase”.
How significant is all of this? We prefaced this discussion by being clear that our traffic lights were designed for use in different times, and we shouldn’t lose sight of that fact. But at the same time, it has also retained its role as an anchor on reality. Sentiment and emotion understandably makes us question how far recent equity performance can continue, particularly with the so-called Trump Bounce looking vulnerable. In our mind, the growth we have seen in equities in the last four or five months has little to do with the Donald. It was going to happen anyway. A stalling of his legislative agenda is meaningless so long as the economy generates 200,000 new jobs every month. Indeed, a stalling of his legislative agenda potentially removes some of the torpedoes he could set off to hole growth below the waterline.
There remain significant risks to UK equity investment. The Brexit process is now reality, and real consequences will follow. Yet it will play out over an extended period of time and management teams will have to get on with running their businesses in the meantime. Doing so against the backdrop of a “Bull Phase” in equity markets as out traffic lights suggest, offers the prospect of further share price growth from here.