In for a penny, in for a pound

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23/07/2018
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We are skipping the politics this week, not that there isn’t anything to discuss, but like everyone we are getting fed up talking about Brexit and Donald Trump, probably just as much as you are fed up about reading it. This week we are focusing on markets and what they may have in store for investors. This is not to say that geopolitical events won’t have an effect on markets, but regardless what happens in the political arena, we believe companies have the ability to adapt.

If presented with two choices which of the following two offers would you take? £1 million pounds or the sum of a penny doubled every day for a month? So on the second day you receive 2 pence, on the third day you receive four pence, and on the fourth day you receive eight pence, and so on. We are assuming there are 31 days in the month. Unsurprisingly, without thinking, most people take the million pounds, however this would be the wrong choice. By taking the penny at the start of the month, by the end you would have received £21,474,836.47. Yes, almost £22 million pounds. Sorry to disappoint readers, but the above is a hypothetical question and regardless of your choice there is no money on offer!

As interesting as this might be, you might be thinking what is the point of this little anecdote? Put simply it illustrates the power of growth. Of course, exponential growth is not reflective of investing, but like compound growth it does show how many people underestimate the power of compounding returns over a period of time. Organic growth of a company coupled with an attractive dividend policy should prevail over any political showmanship.

A good example of this is that since the Brexit (sorry not completely free from politics) referendum the total return of the FTSE 100 has been 35%, however if you were not reinvesting dividends, and on a price comparison basis, your return would have only been 25% - a 10% deficit. Worse still, you could have pulled all your money out the market after the referendum, hence why sometimes it is best to block out any political turmoil.

Source: FE Analytics

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Are markets overvalued? This is the question on most investors lips, but unfortunately this is not binary question, it depends on which metrics are used to assess current market conditions as well as which market is up for discussion. Investors tend to fear growth when there has already been a prolonged period of growth, however, rather than getting jittery investors need to look at the fundamentals and decide whether this growth has been justified and whether it can continue. This can be assessed at a market level or company level.

Domestically focused the FTSE 100 is currently trading around 7,700, which is not too far from its all-time high, but this does not necessarily mean it’s overvalued. One useful metric to determine whether the FTSE 100 is overvalued is by applying the cyclically adjusted price-earnings (CAPE) ratio. This ratio is similar to the P/E ratio, but we believe the CAPE gives a better indication as it uses the average of ten years earnings, adjusted for inflation. By this measure the FTSE 100 currently has a CAPE ratio of 18, which is higher than its traditional average, but it is still one of the world’s cheapest equity markets. By this measure we conclude that the UK market is neither overvalued nor undervalued. By contrast the US has a CAPE ratio of almost 33, which suggests that it is overvalued. Despite the beneficial US tax reforms introduced by Donald Trump we are inclined to agree.

Despite the result of the EU referendum on the 24 June 2016, the FTSE 100 has risen 35%. However, it is still the worst performing market (in local currency) than the other major stock exchanges. Of course, Brexit has weighed on the UK market, but the market always prices in uncertainty so should there be any clarity on what happens post Brexit then we expect to see the FTSE moving higher. The fundamentals of the UK economy still seem fairly robust; unemployment remains at an all-time low, government borrowing continues to fall and, most importantly, company earnings remain resilient. In fact the FTSE currently has a dividend yield just over 4%, higher than its long-term average. The litmus test for investors should be over the week as we enter the earnings season. Companies such as Anglo American, AstraZeneca, British American Tobacco, Diageo, Schroders and many more will be releasing their half-year earnings. Should we broadly see earnings beating forecasts then we should expect the markets to go higher, however, should earnings be subdued then we expect a small pullback.

Source: FE Analytics

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It might not be comfortable investing in the stock market presently, but investors are left with precious little alternatives. Bonds remain unattractive; this is despite the chief economist at the Bank of England calling for an immediate rate rise in August. A small rate rise might close the yield gap between stocks and bonds, but it won’t be the catalyst for investors to flee the stock market for the safety of the bond market, well not yet anyway. Other alternatives such as commercial property remain risky. The business environment is very uncertain ahead of Brexit, so investment into commercial property is low; this coupled with the very well-publicised death of the high-street remains a concern for commercial property investors. Domestically we feel the stock market offers the best returns, although diversification should remain one of the cornerstones of any investment portfolio. This isn’t to say that it is all plain sailing for equity investors; indeed we expect it to be a bumpy ride, especially considering geopolitical tensions which we have tried to avoid discussing this week.

Outside of the domestic market, and as aforementioned, we feel that the US market is overvalued, but we feel there are other opportunities globally. Trade fears has done much to dampen the prospects of emerging markets, however, we feel that these have been overdone and could well mark an attractive entry point should these fears subside.  Despite the Japanese market performing strongly since the reforms that Shinzo Abe introduced we believe that there is further scope for growth in Japan for investors. One of the limitations of the CAPE ratio used to analyse the UK market is that is uses historical earnings from the last ten years. However, due to the reforms in Japan company earnings are now outstripping price growth, hence why Japan has one of the highest CAPE ratios in the world. It goes to show that each market needs to be looked at separately, and unfortunately a one-size fits all approach doesn’t work.

While it is difficult to shift the focus away from political turmoil, both at home and abroad, sometimes it is best to focus on markets. Markets might be jittery because of political uncertainty, but if they have taught us anything, it is don’t underestimate growth, and time in the market is always better than trying to time the market.

Sterling Slump Continues As Macro Data Weakens

Sterling continued to fall last week as weak retail sales and wage growth numbers heaped further selling pressure on the domestic currency. Despite expectations of a modest increase, the warm weather and the beginning of the World Cup were not enough to prevent sales declining by -0.5% during June. Meanwhile wage growth slowed to a 6 month low of +2.5%, broadly in line with inflation which does take some of the pressure off the Bank of England to raise rates again which had been expected to happen next month. Sterling declined by -0.8% against the US Dollar to $1.31 and by -1.1% versus the Euro to just €1.12.

Despite fears of a global trade war, global equity markets recorded modest gains in what was another volatile trading week. At home, the FTSE100 and mid-cap focussed 250 saw growth of +0.2% and +0.5% respectively with the S&P500 flat for the week. Whilst closed on Monday for the celebration of Marine Day, Japanese markets reported gains with the Nikkei 225 rising by +0.4%. European markets were a mixed bag with the +0.2% uplift seen in the German DAX30 offset by a -0.6% decline in the French CAC40.

The weakness in domestic data and subsequent reduced expectations of a rate rise next month saw gilt yields go into reverse with the 10-year dropping by 4 basis points (bps) to 1.28. In the US, the Treasury equivalent yield rose by 6bps to 2.89% - expectations are for further rate hikes before the end of the year, despite the President blaming the recent rally in the Dollar on higher rates. He’s now complaining that will hurt his efforts to bring down the trade deficit (he might actually be right about that one!).

In the commodity markets, oil paused for breath with Brent prices shedding -3.0% to close the week at just over $73.00 a barrel. Unsurprisingly with the Dollar rising once again, Gold was on the back foot with the precious metal declining by -1.1% to $1,229 an ounce. It has now fallen by more than -8.0% over the course of the last 3 months.

The Week Ahead

With summer now in full swing, this week is a quiet one by historic standards with little in the way of information from either the UK or China. In the US, all focus is likely to be on Friday’s Q2 GDP number which is expected to show growth in excess of +4.0%, more than double the level reported in Q1. Other US related data to keep an eye on includes durable goods orders and further housing related numbers in the form of sales (for June). Across the Channel, the ECB hosts its latest policy meeting on Thursday although no changes are expected to interest rates. The flash reading of this month’s production manager indices are released tomorrow although these are subject to change with them only containing 3 weeks’ worth of data. Meanwhile in Japan, the BoJ releases its preferred measure of core CPI inflation in the early hours of tomorrow morning.