World Investment Outlook - Chapter one: UK

March 2019 is drawing ever nearer but the Brexit picture is still unclear, even after Prime Minister Theresa May’s intervention in the Brussels-based negotiations with her September speech in Florence.

November’s talks between David Davis, British Secretary of State for Exiting the European Union, and Michel Barnier, European Chief Negotiator for Brexit, appeared to find some ground on the issue of the UK’s legacy financial liabilities.

This seems to lessen the chance of a “no deal” departure but nothing is set in stone and from a distance it still looks as if none of those involved in the negotiating process no idea of how the Brexit talks may finish. Even though the precedent of the Greek debt crisis suggests some last-minute compromise may be found, it remains nigh-on impossible for investors to second-guess the outcome, although sterling does seem to prefer the so-called ‘soft’  Brexit option, rallying whenever the currency markets convince themselves some sort of phased, transitional deal may be on the way.

A further influence on the pound is the policy framework laid down by the Bank of England, which is talking a tougher game after its first interest rate increase in a decade.

The pound could rally and eat into its post-EU referendum losses if Governor Mark Carney does sanction not just one rate rise but a sequence of them.

Any such gains for sterling could in turn chip away at analysts’ profit and dividend growth forecasts for the FTSE 100 in 2018, given the predominance of overseas earners. An (unexpected) advance in the pound could also focus attention on the downtrodden, domestically-focused sectors which value-oriented managers have been assiduously combing for the past 18 months, albeit with varying degrees of success.

Economics

Whatever the political views of investors when it comes to Brexit, the facts of the matter are that the UK economy did not drop into a hole immediately after the result of the June 2016 EU referendum became known.

Purchasing managers’ indices (PMIs) suggest that corporate confidence is still high in the UK, nearly 18 months after the ballot and less than 18 months before the March 2019 deadline for the UK’s withdrawal from the EU under the terms of Article 50.

Corporate confidence remains relatively robust in the UK

Source: CIPS/Markit, Thomson Reuters Datastream, Trading Economics

Unemployment has continued to rattle lower. The UK has created 379,000 jobs since the EU vote, to take the jobless rate to a 22-year low of 4.3% and the employment rate for 18-to-64-year-olds to 75.3%, the highest figures since records began in 1971.

Relatively resilient retail sales and industrial production numbers have also helped to ensure that the headline GDP growth numbers have held up at respectable, if far from exciting, levels in a range around 2% year-on-year.

Yet one of the reasons for this resilience is perhaps one upon which it would be unwise to rely too heavily. The economy did not drop in a hole because the currency did. At its lows, sterling had lost around 17% against a trade-weighted basket in the aftermath of the referendum.

This may have boosted exports but it increased imported raw material costs and – coupled with a recovery in the oil price back above $60 a barrel – began to fuel a little inflation. As a result increases the headline consumer price index (CPI) and the retail price (index) finally began to show enough some signs of life prodded the Bank of England into its first interest rate increase since July 2007.

UK interest rates since 2007

Source: Bank of England, Thomson Reuters Datastream

But consumer confidence remains weak, wage growth continues to run below inflation and the Bank of England remains convinced that Brexit is more likely to be a negative than a positive once it becomes fact. In a September speech to the International Monetary Fund in Washington in September, Mr. Carney argued that Brexit would hurt growth and at the same time push up inflation (and thus interest rates) as the benefits of low-cost, global sourcing were undone.

Supporters of Brexit will doubtless still counter by arguing that Carney and the central bank should remain neutral on this particular issue but investors in UK stocks or UK equity funds can at least draw some reassurance from past UK interest rate cycles.

UK equities have tended to lose upward momentum six months before – and six months after – the first increase in the Bank of England base rate. The FTSE All-Share has, however, tended to regain its poise and on average make further healthy gains within 12 months of that first policy tightening providing the underlying economy is healthy and corporate earnings growth robust. This was not the case in 1972-73 or 1999-2000 with the result that the All-Share fell sharply.

UK stocks have been able to shake off the first rate rise providing the underlying economy was in good health

Source: Thomson Reuters Datastream

Markets

The UK stock market ranked sixth out of the eight major geographic regions in 2017, when measured in sterling, total-return terms.

UK equities ranked sixth out of eight global regions in 2017

Source: Thomson Reuters Datastream, based on FTSE All-Share index. Total returns in sterling terms, 1 January to 30 November 2017.

Three strong cases can be made for exposure to UK stocks:

1. Aggregate analysts’ consensus forecasts for the FTSE 100 suggest that company earnings are going to advance again in 2018, even after the substantial rebound seen in 2017.
2. Based on aggregate consensus estimates for 2018, the FTSE 100 offers a yield of 4.3%. That figure easily beats anything that can be obtained from (developed market) Government bonds and is based upon the assumption that total dividend payments grow by 7% in 2018 to £89.3 billion.
3. UK stocks are also a good way of playing the prevailing (global) consensus view that the Trump trade will work, and the combination of fiscal stimulus in the US and accommodative monetary policy around the globe will lead to higher growth and inflation. This is because over half of the index’s forecast profits come from banks, insurers, miners and oils, all sectors which should benefit from a more buoyant US and global economy or the increase in bond yields and maybe interest rates which would follow GDP higher.

If profit momentum owing to a weak pound, dividend yield and the combination of cyclical and global earnings streams make a strong case for exposure to UK stocks, it is nevertheless easy to spin a bearish case – and one based on the same three factors for good measure.

1. Although the FTSE 100’s dividend yield is attractive, it may not be entirely safe. Pearson, Provident Financial and Admiral did push through dividend cuts and the overall level of dividend cover is low by historic standards. Ideally, investors will want to see total profits cover total dividends by two times or more – this provides some safety in the event of a sudden economic shock or company-specific problems. Yet aggregate FTSE 100 cover is just 1.6 to 1.7 times for 2018, a historically low figure as we can see here, so if there is an unexpected downturn then dividends – and that yield – could come under pressure.

   FTSE 100 dividend cover is thin by historic standards
   

   

   Source: Company accounts, Digital Look, consensus analysts’ forecasts

2. Earnings forecasts have started to run out of puff. After increases to aggregate FTSE 100 pre-tax income forecasts for 2017 in Q2, Q3 and Q4 of last year and Q1 of this, estimates flattened out in Q2 and then slid by 3% in Q3. Estimates for combined profits in 2018 have been flat at around £215 billion for the last two quarters. This loss of momentum may help to explain why the FTSE 100 went nowhere fast in the second half of 2017.
3. The FTSE 100 is heavily skewed in terms of its market cap, income and dividends to just three or four sectors: financials (and banks in particular), miners and oils. None of them offers a predictable or reliable earnings stream and investors must be aware that the quality of UK plc’s earnings is therefore not especially high, even if the quantity currently looks satisfactory.
   

Banks, miners and oils dominate FTSE 100 growth forecasts for 2018

Source: Company accounts, Digital Look, consensus analysts’ forecasts

Nine FTSE 100 firms – AstraZeneca, BT, Burberry, Convatec, Merlin, Next, Pearson, WPP and the now ex-constituent Provident Financial have all fallen by more than 10% in one single trading this session this year. This shows how the market is becoming less tolerant of earnings disappointments so for the FTSE 100 to make serious advances in 2018 both profits and dividends will need to live up to, or exceed, consensus forecasts.

Russ Mould, AJ Bell Investment Director

Next chapter

Read more from our World Investment Outlook 2018 series:

World Investment Outlook - Chapter one: UK

World Investment Outlook - Chapter two: USA

World Investment Outlook - Chapter three: Japan

World Investment Outlook - Chapter four: Asia

World Investment Outlook - Chapter five: Western Europe

World Investment Outlook - Chapter six: Emerging Markets