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FTSE 100 loses earnings momentum again
Brexit continues to dominate the headlines as the 31 October deadline for a withdrawal by the UK draws near and equity, bond and currency markets are becoming more volatile as a result.
The dangers of second-guessing the outcome of the talks between Britain and the EU are clear from how the FTSE 250 index soared by more than 800 points, or 4%, one day (11 Oct) only to shed more than 200 points during the next trading session (14 Oct) as hopes for a deal rose and then fell.
Sterling made big gains and then losses, too, while the yield on the 10-year Gilt rose from 0.46% to 0.71% in a single day before falling back.
Given that no-one – not even the politicians involved in the talks – knows what is going to happen it is either very brave or very foolish of investors to try to second-guess and trade the outcome.
Narrative does not determine investment returns. Even relatively inexperienced investors can spot a good story and swerve a bad one. Rather it is the price paid and the valuation accepted to access the profits, cash flows and dividend stream of an index in aggregate, a sector in total or a specific stock that is the ultimate arbiter of investment returns.
PRICE MUST BE RIGHT
The good news is that it is possible to make a case for UK equities being cheap, especially after a period of underperformance on the global stage that pre-dates the summer 2016 EU referendum vote by some distance. Over the past 10 years, the UK stock market, as benchmarked by the FTSE All-Share has provided a total return in sterling terms of 104%.
That lags not just the rip-roaring US equity market but Japan, Asia and even Western Europe as well (with sterling’s decline playing part). UK equities have outperformed only emerging markets, not developed ones.
As a result of this moderate showing, it can be said that UK equities look cheap relative to their international peers and to their own history on just 12.7 times forward earnings for 2020, with a dividend yield of 4.6%.
That dividend yield in particular may catch the eye of income-seekers, as it is the highest figure on offer from any of the eight major geographic equity market options and represents a premium of more than four hundred basis points (or four percentage points) relative to the benchmark 10-year Gilt yield.
Investors need to ask themselves: are the earnings and dividend forecasts which underpin those tempting valuation metrics any good?
The good news is the aggregate consensus analysts’ forecasts for 2020 do not look unduly aggressive. Looking at the FTSE 100 alone (and this represents some 85% of the UK’s market cap) analysts’ estimates are calling for revenue growth of 2%, to an all-time high of £1.85tn; pre-tax profit growth of 8%, to an all-time high of £238bn; dividend growth of 3%, to an all-time high of £95.1bn (even excluding special dividends)
Granted, if the UK economy slips into an unexpected recession, and is joined there by, say, the US, then such figures are likely to prove wildly optimistic.
Equally, the numbers could prove to be too low if the British and global economies prove more resilient than the current consensus amongst analysts and economists would have us believe. And the trio of all-time highs would lead investors to ask why the FTSE 100 is still trading some 8% below its May 2018 closing peak of 7,877.
The issue is perhaps that investors are wary of the reliability of the forecasts. Unfortunately, we can see how aggregate earnings estimates have begun to slip a little for 2019 and 2020, as downgrades at the banks outweigh upgrades at the miners:
By contrast, dividend estimates are still sneaking higher. That offers some encouragement but you do have to wonder how long that trend can continue if profit forecasts are leaking lower at the same time.
The absence of profit forecast upgrades does leave the UK equity market bereft of one possible catalyst for performance. But someone, somewhere still thinks the combination of lowly earnings valuations, a fat yield and a depressed currency offers some value, judging by the rash of bids for quoted UK firms from foreign rivals.
Sophos (SOPH) is just the latest example after ARM, Sky, Punch Taverns, Premier Farnell, Brammer, Greene King (GNK) and many more besides. If overseas captains of industry think there is value to be had, perhaps investors should be paying attention.