The stockmarket in the UK hit a new all-time high in early November, but it would be hard to describe the recent UK financial and business press headlines in recent months as unambiguously good news. What’s going on?
Mixed signals from the economy
Brexit is one of the most popular themes, with the continuing uncertainty over the precise details of the relationship between the UK and the European Union. A second popular theme is UK productivity, or output per worker per hour, which has been falling this year according to the recent official statistics. A third theme which occupies a great deal of space in the financial press is the policy decision-making at the Bank of England and the Treasury.
The Bank of England is worried about the lack of slack in the economy, as illustrated by the low unemployment rate, and consequently raised interest rates in early November ‘in order to return inflation sustainably to the target’ (which is 2% and set by the Chancellor). But better-than-expected economic growth has enabled Philip Hammond to increase spending in the near term and still aim to balance the books within a decade. Encouragingly, the manufacturing sector’s performance has improved, export order books are booming and the overall profitability of UK-listed companies has increased.
Supportive corporate sector
Taking all of this together, it seems like a mixed environment for financial assets in the UK. However, the stockmarket reflects the present value of future dividends from UK plc, which are influenced both by profit growth and the discount rate (a reflection of time and the amount of risk) applied to those dividends. The corporate sector is benefiting from a more competitive level of sterling, thanks to the Brexit-related weakness in 2016. Rising oil and other commodity prices are also good news for their market sectors. But the growth in corporate profits is more broadly based, with those in the consumer and financial sectors rising at a healthy pace as well. Another factor that has supported companies in the past year is that the global economy is experiencing a synchronised recovery for the first time in decades, and around 70% of the revenues earned by the companies listed on the UK stock exchange are derived overseas. In aggregate, therefore, stockmarket profits are growing at a faster rate than expected a year ago.
This positive corporate backdrop provides a fundamental support to equities (company shares) and is especially good news since it represents a change in trend from the 2012-2016 period when profits were falling overall. The increase in earnings per share since the summer of 2016 has been greater than the rise in the overall market level, which has resulted in the market’s forecast earnings yield1 rising modestly, even as the price level of the market has improved. Although the rise in earnings yield is not huge – on the blue chip FTSE 100 Index of larger companies, it has risen from 6.1% to 6.8% – this has taken place during a time when some other markets have experienced a fall in their earnings yield. The US stockmarket, as represented by the S&P 500 Index, for example, has experienced a reduction in earnings yield from 5.8% to 5.4% over the same time period.
Lingering investor caution
The earnings yield is a measure of the valuation of the market. A higher level of earnings yield indicates that a higher level of return is priced into the market to compensate investors for perceived risks. Why would investors in the UK equity market require a higher return now than in the summer of 2016, while investors in the US equity market are content to be paid a lower return? In part this reflects changes in risk appetite over time. In the UK there is still a level of risk aversion that reflects some of the factors mentioned above, as well as concern about the future growth of the economy in a post-Brexit world. By contrast, US equities embody a lower level of concern, or greater optimism, about the outlook than the UK. Some of this is due to sectoral differences such as a higher weighting in IT in the US market.
Priced for a reasonable long-term return
The UK economy has continued to surprise the consensus of economists over the past couple of years – a reminder that forecasting economic growth and dividends is not an exact science. But we do know that the UK stockmarket is priced to deliver a reasonable return, albeit that this return is likely to arrive in a volatile2 way. For long-term investors, the UK stockmarket remains attractive.
1. The earnings yield of a market index is the aggregate earnings of its constituents (either forecast or historic) divided by the current capital value of the index; expressed as a percentage, the metric is one method for gauging a market’s value – eg if the yield is low, the market is priced to deliver a low return and vice versa.
2. When the value of a particular share, market or sector swings up and down fairly frequently and/or significantly, it is considered volatile.