It is one thing to be cautious about the prospects for the UK market – but quite another to be bearish about every stock listed in the UK.
To modern minds, the notion that something true for the whole must also be true for its constituent parts is self-evidently false. But that has not always been the case. Aristotle had to argue against ‘the fallacy of division’ – the assumption that atoms of water would necessarily be wet or that atoms of wool must be soft. If they are not to squander the opportunities in front of them, investors must resist committing the same logical error as the ancient Greeks.
Our point? That it is one thing to be cautious about the prospects for the UK market – but quite another to be bearish about every stock listed in the UK. That may seem like a simple distinction – but it is important. Our views on the UK market are cautious but our views about some of the companies it contains are rather different. Like all good logicians, we start with the general but proceed to the specific.
A challenging transition
On the prospects for the UK market as a whole, we are cautious. The first reason for our wariness is that we are bearish on emerging markets. To reflect their reduced circumstances, governments, companies and households in what were recently some of the world’s fastest growing economies are under huge pressure to rebalance their budgets.
We struggle in particular to find reasons to be bullish about China. For years, my view has been that its destiny might be to become something like Japan, with an unhelpful demographic profile, a high savings rate, poor prospects for long-term growth and debts run up by corporate sector finding their way onto the government’s balance sheet. As Japan’s experience since its asset bubble burst in 1989 has shown, that journey is unlikely to be either quick or smooth. In fact, Japan now looks like a best-case scenario for China. The vast cities that were built on credit in anticipation of continued growth in the extractive industries – coal, steel and aluminium – now look woefully misjudged.
Industrial slowdown
There are also reasons to be cautious about economies across the West. Results from industrial companies point to a rapid deterioration in the industrial sector of Western economies; survey readings in the US and in Europe concur. Part of that is a consequence of slower growth in emerging markets. But it is also a consequence of the collapse in commodity prices. In the UK, companies like BP are cutting spending aggressively. It isn’t just the industrial economy that is seeing a crisis of confidence: animal spirits across the corporate world have dimmed.
Another reason for gloom: dividend cover has fallen to a 30-year low. With yield in short supply since the financial crisis, companies have been rewarded with higher share prices for increasing their dividend payouts. Unfortunately, some now find that the earnings expectations needed to support those dividends were too optimistic. They will be forced to cut their payouts. We’ve already seen evidence of this happening among the food retailers, miners and even the utilities. Big dividend payers in the telecoms, oil and pharmaceutical sectors will now need to show earnings growth if their dividends are to be sustained.
Reasons to be cheerful, selectively
There is, however, some good news. We remain positive on the prospects for consumers in the US and UK, where falling unemployment causes us to anticipate a meaningful and sustained increase in wages. Higher real wages are a precondition for a normalisation of interest rates; in their absence, it would be hard for consumers to service their debts. And although real wages have increased over the past year, that has been because headline inflation has fallen. Wage growth of 2½-3½% would instil greater confidence in investors and central bankers that their economies could support a more ‘normal’ monetary policy.
Moreover, the relative valuation of UK stocks suggests that investors ought – in time – to make money by owning equities. That becomes clear once we compare the earnings yield on equities (a theoretical measure of what you would receive if companies were to pay out all of their earnings as dividends) to the yield on 10-year gilts (UK government bonds). During my time as manager of Standard Life Investments’ UK Equity Unconstrained Fund (which I ran before joining Artemis last year) I found the gap between these two data series to be a useful yardstick for measuring the opportunity in equities. At present, that gap is fairly wide. Although it could widen further, it does indicate that investors should, over time, receive a more attractive return from owning UK equities than other assets, including government bonds, which are perceived to carry less risk.
The trend in earnings across the UK market as a whole has not been encouraging. In fact, if we look at the FTSE 100 index, adjusted earnings growth was – on aggregate – negative in 2013 (-8.6%), 2014 (-1.2%) and 2015 (-15.8%) as pharmaceuticals, banks and commodity stocks struggled. That explains why UK market indices – and the funds that track them – have failed to make much progress in recent years: investors’ growing optimism has been undermined by the failure of earnings to materialise. And, given that commodity prices have fallen again since the New Year, earnings from the UK market seem likely to fall again in 2016.
It is important, however, to draw a distinction between the earnings performance of the market and that of the individual companies it contains. Unless they own a passive fund and thereby commit themselves to holding large positions in structurally challenged sectors, discriminating investors can find companies whose cashflows will grow over time. The earnings performance of the median stock in the FTSE 100 and 250 indices has been vastly superior to aggregate earnings from those indices.
So even in a UK equity market beset by challenges, there will be opportunities for investors who are prepared to look beyond the general and focus on the specific. It is only logical.
Ed Legget manages the Artemis UK Select Fund
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