For much of the second half of last year, we tempered our general optimism for positive UK equity returns with a growing realisation that the serene nature of the upward drift in global markets might be distorting the appropriate pricing of risk. Indeed, this was not just a factor for equity markets – bond market assumptions on credit risk and inflation risk were equally difficult to justify within the bounds of historic norms. Since the turn of the year these cautionary musings have proven prescient.
In broad terms, volatility is back. Monetary policy in the UK and US looks unwavering in its upward trajectory. This, as we have discussed, puts pressure on equity valuations. Whilst last year markets were willing, largely, to ignore political risks, the prospect of a US trade war with the Chinese and a return to Le Carré-style shenanigans between the West and the Russians have helped foster a sense of unease over the stability of the politico-economic consensus that has endured for most of the last thirty years. On top of this, there is clear evidence on the ground in the UK that the nature of many industries are changing in the face of structural over capacity, sustained cost pressures, or changing consumer habits. Furthermore, the analysis of structural industry changes is being clouded by a tougher cyclical environment. It is not clear where cyclical problems stop and structural problems start.
Yet, rather than shying away from this, the rational investor should be diving for the annual reports and spreadsheets. From volatility comes opportunity.
For the umpteenth time since the financial crisis, “sell UK” is the consensus trade. There is a lot of logic behind this; the UK’s economic growth has slowed to leave it lagging other major developed nations. Its population is still living on real terms incomes that are lower than a decade ago, and they are still being eroded by inflation that is higher than wage growth. It is facing an uncertain trading relationship with the rest of the world in a year’s time. This is all well known. Which, ironically, is where the opportunity lies – because like any period of economic uncertainty, retrenchment and restructuring, it will create winners as well as losers. And the businesses that emerge from this will typically be stronger and leaner as a consequence. However, in the meantime, markets have a habit of marking all businesses down in unison.
The opportunity is there. The key issue is how to exploit it. That, I’m afraid, goes back to that hoary old chestnut of identifying the difference between share price volatility and risk. This morning’s announcement from Conviviality is a salient case study in the major sources of risk – aggressive expansion, poor internal controls, thin cash flow, and an over-geared balance sheet are all factors that can permanently damage shareholder equity. Buying established, profitable, cash-generative businesses might not always be fashionable, but it usually means that you have kept your skin in the game for the time when things improve.
It is notable that this month saw the FTSE100 Index fall back below the 7,000 level again. It is in some ways remarkable that this is the same level that it reached a full eighteen years ago. Yes, we have to recognise that we have received eighteen years of good income out of equities over that time, so it does not tell the full story of equity returns. However, it is surprising that the capital return of the market’s largest companies over that time has barely changed.
This highlights two points. Firstly, the FTSE100 was undoubtedly over-valued at the end of the 1990s; buying excessively valued investments doesn’t necessarily damage your wealth permanently, but it can take a long time thereafter to show a profit on the ledger. The second point is that eighteen years of economic progress (only two of those years showed economic decline) is likely to be largely unrecognised in equity values.
On that latter point, readers may retort “you would say that, wouldn’t you”, but the exceptionally high level of corporate activity from overseas buyers of UK businesses suggests that more impartial minds than ours think much the same thing.
With the Easter weekend approaching, can we hope that all our friends have a restful time, and that the weather is finally more conducive to whatever outdoor activity you find yourself getting up to. For those partial to a chocolate egg, we equally hope that the Easter Bunny is feeling generous. For those that are not, our Marketing Director will accept all unwanted varieties.