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Investing in the UK is far from a lost cause

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Back in 2015 the FTSE 100 hit 7,000. It was quite exciting. Today the FTSE 100 is 5,876. Not so exciting.

Shares in some of our flagship companies look awful. Rolls-Royce hit a 17-year low this week. Royal Dutch Shell is down 60 per cent this year alone. Things haven’t been quite so awful across the board — the FTSE 250 is roughly unchanged overall since 2015. But it is still down 21 per cent this year.

All of this has hit our global position. The UK market as a share of both the European and global equity markets is the lowest since the 1970s. The whole thing in a nasty nutshell: a few weeks ago Apple became worth more than the FTSE 100 index.

You will say that this all makes sense. The UK market is dominated by the kind of companies no one wants any more — banks, miners and old-fashioned energy. No priced-to-infinity tech stocks here. We’ve also had a horrible time with Covid-19. And our economy is a mess, and one that is about to get a million times worse with Brexit.

This misery argument is very easy to make. One number that makes the case is the percentage of commercial rents collected by the time the third quarter ended this week. UK retailers have paid just over 12 per cent of the rent due for the quarter (that’s even less than at the end of the June quarter). The office sector was better — 32 per cent of the rent was collected, compared with 22.7 per cent at the end of the second quarter. Better, but still carnage.

The unemployment this kind of number hints at might have been delayed by the endless and confusing set of compensation schemes being put in place to counter the endless and confusing lockdown policies. But it will still come: the Bank of England is looking at 7.5 per cent unemployment by the end of the year.

These numbers are so easy to find that it is perhaps too easy, as Andy Haldane puts it, to “catastrophise” the discussion — “to dismiss good news and dwell on bad.” Mr Haldane, chief economist at the Bank of England, is expecting 20 per cent GDP growth in the third quarter. The economy, he says, has already recovered “far faster than anyone expected”.

The number of people in work in the UK has so far fallen by only 0.7 per cent since the pandemic started. Retail sales are back to pre-pandemic levels. UK factory activity grew for the fourth month in a row in September, based on the IHS Markit/Cips Manufacturing Purchasing Managers’ Index.

And Brexit? Perhaps we worry too much. As Capital Economics noted, at this point there isn’t that much of a difference between a deal and no deal. That’s partly because leaving the customs union and the single market makes the Brexit we have chosen a relatively hard one anyway. But it is “mostly because a lot of arrangements have already been put in place”.

Trade deals have been replicated. There has been much progress on financial services equivalence and exporters have had plenty of preparation time. In the great scheme of things it might turn out to be much less of a big deal than it seems right now.

If you are prepared to open your mind to the idea that the UK is not a lost cause (it isn’t) and that the headwinds we face are fairly temporary (they are), the UK stock market suddenly looks very interesting. As Alan Brierley of Investec points out, our equities are “approaching pariah status”. They are now trading on the greatest discount to global equities for 50 years — with UK value stocks trading at their greatest discount to their growth counterparts ever.

Yes, ever — despite the fact that the past 25 years of long-term data always shows value investing outperforming growth. Fund managers are generally known more for their bandwagon jumping than their contrarian thinking skills. But with things at this kind of extreme even they are beginning to think there might be opportunity here.

What if Brexit passes without the world ending? And dividends payouts return? Even if UK banks don’t start paying dividends again, AJ Bell reckons the UK yield will be 3.7 per cent next year. What if the world recognises that it needs our miners? You can’t have electric cars without copper. Or we dump lockdown as our anti-Covid strategy? Or the pandemic forces a sudden rise in productivity upon us? Any of these things could prompt a bit of a rethink.

On then to Temple Bar, a value-oriented UK investment trust (that I hold) and that has acted as a poster boy for the appalling performance of our stock market recently. It’s down 50 per cent in the past year. It lost its long-term manager in the spring and has just announced the new ones: Nick Purves and Ian Lance of RWC Asset Management.

The good news is that the board appears to have been unmoved by the appalling performance of the past strategy in making a decision on their new one. Mr Purves and Mr Lance are firm value adherents — now more than ever. There have been, they say, only three occasions in their careers “when dislocation in the stock market has created the most exceptional opportunities for value investors: post the technology bubble of the late 1990s; coming out of the global financial crisis; and today”. Brave words.

You can buy shares in Temple Bar on a discount of 14 per cent to their net asset value and a prospective dividend of 6 per cent (the discount reflects the bravery). Otherwise there are a few new names raising money at the moment (this really is contrarian). The new Tellworth British Recovery and Growth Trust (which you can buy into on PrimaryBid) aims to do exactly what it says on the tin.

The Schroder British Opportunities Trust plans to invest in both undervalued private and listed companies (there is a touch of bandwagon jumping in the private bit, of course). Finally there is the Buffettology Smaller Companies Investment Trust, which is looking to raise £100m with a view to value investing among the smallest of UK-listed firms.

All look interesting — although as ever with investment trusts I’d be inclined to wait until they list and hope to buy at a discount rather than pointlessly pay full price for shiny new shares.

Professional investors will insist on being able to put a time on a trigger for change, since vague lists like the one I have made above don’t count for them. Ordinary investors don’t need to bother with that.

No one cares about our quarterly performance, thankfully. We just need to know that cheap UK equities will break out at some point. And that when it happens, in the words of Angus Tulloch, adviser to Kennox Strategic Value Fund (which I also hold), it will “happen very quickly”. Best be ready.

Merryn Somerset Webb is editor-in-chief of MoneyWeek. Views are personal. merryn@ft.com Twitter: @MerrynSW





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US stocks make gains on Fed message of patience over monetary policy

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Stocks on Wall Street reversed earlier losses after Jay Powell, the Federal Reserve chairman, reiterated the central bank’s desire to stick with accommodative policies during his second day of testimony to Congress.

The tech-heavy Nasdaq Composite ended the day up 1 per cent, having fallen almost 1 per cent at the opening bell. The S&P 500 climbed 1.1 per cent, marking the blue-chip benchmark’s second consecutive rise after five sessions of back-to-back losses.

A morning sell-off in US Treasuries also faded, with the yield on the 10-year note having climbed as much as 0.07 percentage points to slightly less than 1.43 per cent, its highest level since February last year, before settling back to 1.37 per cent.

Treasuries have been hit by expectations that US president Joe Biden’s $1.9tn stimulus plan will stoke inflation, which erodes the cash value of the debt instruments’ interest payments. However, the more recent rise in yields has also been accompanied by a rise in real rates, which are more indicative of the return investors make after inflation and signal an improving growth outlook for the economy.

Higher yields, which move inversely to the price of the security, also knock-on to equity valuations by affecting the price-to-earnings multiples investors are willing to pay for companies’ shares. A higher yield, analysts say, makes fast-growth companies whose earnings represent a slim proportion of their stock market value less attractive in comparison.

Shares in the 100 largest companies on the Nasdaq are valued at a multiple of 37 times current earnings, against 17 times for the global FTSE All-World index of developed market equities.

“When bonds yield close to zero, you are not losing out by investing in those companies whose cash flows could be years into the future,” said Nick Nelson, head of European equity strategy at UBS. “[But] as bond yields start to rise, that cost of waiting [for companies’ earnings growth] increases.”

Earlier on Wednesday, investors’ retreat from growth stocks rippled into Asia. Hong Kong’s Hang Seng index sank 3 per cent, its worst daily performance in nine months. Chinese investors using market link-ups with bourses in Shanghai and Shenzhen dumped Hong Kong-listed shares at a record pace, selling a net HK$20bn ($2.6bn) on Wednesday. China’s CSI 300 index fell 2.6 per cent. Japan’s Topix slipped 1.8 per cent, dragged down by tech stocks.

Column chart of Hang Seng index, daily % change showing worst day for Hong Kong stocks in 9 months

European equity markets closed higher, with the Stoxx 600 regional index rising 0.5 per cent and London’s FTSE 100 index up 0.5 per cent. UBS’s Nelson said European equities were less vulnerable to rising yields because European stocks generally traded at lower valuations than in Asia and the US. “We have fewer big technology companies here.”

While the bond market ructions have unsettled many equity investors, some believe this should not affect stock markets because the inflation expectations that have driven the Treasury sell-off are linked to bets of a global recovery.

“Rising bond yields and rising inflation from low levels provide a historically attractive environment for equities,” said Patrik Lang, head of equity strategy and research at Julius Baer. Traditional businesses whose fortunes are linked to economic growth, such as “industrials, materials and especially financials”, should do better in a reflationary environment than tech stocks, added Lang.



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Fed needs to ignore ‘taper tantrums’ and let longer rates rise

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The writer is chief executive officer and chief investment officer of Richard Bernstein Advisors 

The Ferber Method, a sleep training technique, teaches babies to self-soothe and fall asleep on their own. It’s as much a training technique for new parents to ignore their baby’s crying as it is for the child to learn to cope by themself. 

The US Federal Reserve should consider Ferberising bond investors and ignore future “taper tantrums” like the market disruption that occurred when the central bank signalled tighter monetary policy in 2013. The long-term health and competitiveness of the US economy may depend on bond investors’ self-soothing ability to cope with reality.

The slope of the yield curve is a simple model of the profitability of lending. Banks pay short-term rates on deposits and other sources of funds and receive longer-term rates by issuing mortgages, corporate loans, and other lending agreements.

A steeper curve, therefore, is a simple measure of better bank profit margins, and has in past cycles spurred greater willingness to lend. Historically, the Fed’s Survey of Senior Bank Lending Officers shows banks have been more willing to make loans to the real economy when the yield curve has been steeper.

A chart showing how banks have been more willing to lend with a steep yield curve. As the slope on the US treasuries  10-year-less-2-year yield curve has steepened, so the net percentage of banks reporting tighter lending standards has fallen

With that simple model of bank profits in mind, textbooks highlight the Fed’s control of short-term interest rates as a tool to control lending. The Fed reduces banks’ cost of funding and stimulates lending when it lowers interest rates. But it increases funding rates and curtails lending when it raises short-term rates. Coupling lower short-term rates with a steeper yield curve can be a powerful fillip to bank lending. 

However, policies in this cycle have been unique. As US short-term interest rates are near zero, the Fed has attempted to further stimulate the economy by buying longer-dated bonds and lowering long-term interest rates. Those actions have indeed lowered long-term borrowing costs in the economy, but banks’ willingness to lend has been constrained because lending margins have been narrow and risk premiums small.

Banks in past cycles might have been willing to lend despite a relatively flat yield curve because they could enhance narrow lending margins by using leverage. However, regulations after the financial crisis now limit their ability to use leverage.

This policy and regulatory mix has fuelled some of the growth in private lending. Private lenders are not subject to regulated leverage constraints and can accordingly lend profitably despite a flat curve. The growth in private lending effectively reflects an unintended disintermediation of the traditional banking system. This has meant liquidity destined for the real economy has largely been trapped in the financial economy.

The yield curve has started to steepen, and the Fed should freely allow long-term interest rates to increase for monetary policies to benefit the real economy more fully. Allowing long-term rates to increase would not only begin to restrain financial speculation as risk-free rates rise, but could simultaneously foster bank lending to the real economy. 

Thus, the need for the Fed to Ferberise bond investors. Banks’ willingness to lend is starting to improve as the curve begins to steepen, but some economists are suggesting the central bank should continue its current strategy of lower long-term interest rates because of the potential for a disruptive “taper tantrum” by bond investors. The Fed needs to ignore investors’ tantrums and allow them to self-soothe.

The investment implications of the Fed allowing longer-term interest rates to rise seem clear. Much of the speculation within the US markets is in assets such as venture capital, special purpose acquisition vehicles, technology stocks and cryptocurrencies. These are “long-duration” investments that have longer-time horizons factored into their valuations. They underperform when longer-term rates rise because investors demand higher returns over time. Capital would be likely to be redistributed to more tangible productive assets.

Investors and policymakers should be concerned that monetary policy is fuelling speculation rather than supporting the lending facilities needed to rebuild the US’s capital stock and keep the country’s economy competitive.

Like a new parent to a baby, the Fed should not rush to coddle bond investors’ tantrums and should let the financial markets soothe themselves. Short-term financial market volatility might cause some sleepless nights, but the Fed could unleash the lending capacity of the traditional banking system by letting the yield curve steepen further.



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What we’ve learned from the Texas freeze

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One thing to start: While the freeze in Texas caused havoc for most, some companies have reaped big rewards. Australia’s Macquarie Group said yesterday full-year profits could rise by up to 10 per cent as a result of a surge in demand for its natural gas shipping business.

Welcome to today’s newsletter, where Texas remains in focus. In our first item, Derek Brower asks if oil’s modest price rise in reaction to last week’s events signals that the rally will soon run out of steam.

Further rises, after all, will only tempt America’s shale producers to dive into growth mode. For our second item, Justin Jacobs speaks to Devon boss Rick Muncrief about when the taps will be turned back on.

Elsewhere we round up the key reading on the Texas fallout from the FT and beyond; ask how the appointment of a general to head up Brazil’s Petrobras has gone down in the markets (hint: not well) and bring you the latest on the proxy battle to green ExxonMobil.

Thanks for reading. Please get in touch at energy.source@ft.com. You can sign up for the newsletter here. — Myles

Is the oil rally nearing the end of the road?

Texas’s cold snap last week lifted oil prices — yet still brought a warning for the market’s bulls. The Permian Basin, the world’s most prolific oil-producing region, froze up. US production fell by 2m barrels a day, according to Wood Mackenzie. Kpler, a data provider, estimates the country’s total output in February will be down by 1m b/d.

By Tuesday morning, after it emerged that producers would take weeks to fully restore flows, US oil futures were trading for around $62.50 per barrel, just $2.50 or so more than its price on the eve of the snowstorm. Hardly an Abqaiq-style oil-price leap.

One explanation is that huge volumes of refining capacity are offline too, removing a big source of demand and neutralising some of the supply disruption. But the market’s relative calm also begs questions about how resilient oil’s rally is — especially with an Opec meeting next week, when the cartel must decide how much, if any, of its 7m barrels a day or more of offline supply it will begin restoring.

Many analysts remain bullish. Goldman Sachs, Wall Street’s most influential oil-price forecaster, upped its expectations by $10 a barrel this week. It now expects Brent, which was above $66 on Tuesday morning, to hit $75 in the third quarter.

Line chart of US crude production showing The big Texan freeze

Yet the bull case increasingly depends on many things coming true at once, points out Neil Atkinson, an independent analyst who was formerly head of oil markets at the International Energy Agency. Sanctioned Iranian barrels must remain offline; US supply must remain constrained; and economies must rebound quickly. Above all, Opec must keep cutting.

Current prices are in a “sweet spot” for the cartel, said Atkinson. But any further price rises could prompt a response from shale (see below) and test Opec’s discipline, prompting a response from its biggest producer.

“Over the years, Saudi Arabia has shown its willingness to shift policy and maximise output if compliance falls and/or if the perceived costs of co-operation exceed the perceived benefits,” wrote Bassam Fattouh, head of the Oxford Institute for Energy Studies and a Saudi oil-policy expert, in an article explaining the kingdom’s recent decision unilaterally to deepen its owns cuts.

“Thus, Saudi Arabia can easily swing in the opposite direction in response to low compliance and given the relatively low level of Saudi production, the size of the upward swing could be quite substantial, as was the case in April 2020.”

(Derek Brower)

American oil market eyes production boost

After the oil-price surge of recent weeks, the big question hanging over the US shale patch, and broader oil market, is when American producers will start loosening the purse strings and opening up the taps.

That point might now be visible on the horizon. “If we do see commodity prices rapidly increase back to $70 or $80 a barrel, you’re going to be generating a lot of free cash and that gives you a lot of optionality on things you could think about,” Rick Muncrief, chief executive of Devon Energy, a major Permian producer, told ES last week.

For now, Muncrief’s company is keeping a 5 per cent cap on production growth and promising a windfall for shareholders if prices keep climbing. “First things first, we want to make sure we stay disciplined,” Muncrief said.

But his comments to ES point to when companies might ditch the capital discipline mantra and become more vocal about their ability to both accelerate output growth and keep cash flowing to shareholders.

Robert Kaplan, head of the Dallas Fed, also talked about the potential for oil producers to pivot away from capital discipline as prices rise. “I’ve learned sometimes if prices get high enough mindsets can change,” he told an International Energy Forum conference yesterday.

“To get back to 13m barrels a day, yes, you would need a change in mindset. Probably spurred by higher prices. Can I predict whether that will or won’t happen? No I can’t predict it, but I think we should be on watch for it,” Kaplan said.

We will get more of an idea of the mood in the shale patch later this week, after Pioneer Natural Resources, EOG Resources, Diamondback Energy, Occidental Petroleum and Apache have all reported earnings.

Expect a lot of talk about when producers might start getting back into the growth game. (Justin Jacobs)

What to read on the Texas freeze

A weeklong catastrophe left millions without power and heat amid some of the coldest weather the state has seen in a century.

The failure of the state’s electric grid caused immense human suffering, financial pain for consumers (and gain for some energy companies), and has spawned a wide-ranging conversation about where things went wrong and how to prevent it from happening again. Here are the key pieces to read:

  1. Start with Bloomberg’s in-depth account of the early hours of Monday morning, when the state’s grid operator, the Electric Reliability Council of Texas, was forced to plunge millions into darkness as power generation seized up.

  2. The International Energy Agency put the pieces together here in a broad overview of how the grid broke down — and points out that the lessons from Texas should be learned far and wide, especially as the world becomes increasingly electrified and vulnerable to disruptions.

  3. Gregory Meyer and I covered the financial fallout from the storm, including the story of one family in Burleson, Texas, which saw their electric bill suddenly spike to more than $8,000. We also explored who the winners and losers were in a $50bn bonanza of power trading.

  4. Some companies that cashed in on the crisis are being accused of profiteering. The gas producer Comstock Resources said surging natural gas prices were like “hitting the jackpot”.

  5. The crisis sparked an inevitable debate pitting renewables advocates against fossil fuel backers. This green versus brown debate generated much more heat than light. But the issue of intermittent renewables’ reliability is a critical one. The FT’s editorial board argued that frozen wind turbines were hardly the main cause of the grid’s collapse as the natural gas system, which has the largest share of the power market, also failed.

  6. A less sexy but probably more important issue is why so much of Texas’ energy system was so easily felled by temperatures that much of the rest of the country sees on a regular basis. This excellent Texas Tribune story looks at why “winterising” power plants, pipelines and wells might not be as easy or cheap as state officials hope.

  7. Finally, there is a fascinating debate over the role climate change did or did not play in the Arctic blast. My colleagues Leslie Hook and Steven Bernard have a nice explanation (and graphic) of how the jet stream bent south, covering Texas in freezing arctic air.

(Justin Jacobs)

Data Drill

Shares in Petrobras fell off a cliff yesterday as the market absorbed Brazilian president Jair Bolsonaro’s decision to oust the state oil group’s chief executive in favour of a general.

Bolsonaro had blamed Petrobras’s erstwhile boss Roberto Castello Branco for recent rises in petrol and diesel prices, which had provoked the ire of the country’s truck drivers.

Strikes over fuel costs in 2018 paralysed Brazil’s economy and sapped support for the government, helping secure Bolsonaro’s election to office.

Line chart of Share price (Brazilian reals) showing Petrobras shares plunge after Bolsonaro ousts CEO

Power Points

Endnote

The proxy battle at ExxonMobil rumbles on, with activist group Engine No.1 blasting the oil major’s assertion that its carbon-cutting plan was in line with the Paris accords.

Exxon has stuck to its guns as an oil producer even as rivals like BP and Shell lay out plans to shift into greener sources of energy and reduce fossil fuel output. But it has made concessions in the face of investor pressure, including pledges to cut emissions intensity by 2025.

This month the company said that its emissions targets were “projected to be consistent with the goals of the Paris agreement” and would position it to be “an industry leader in greenhouse gas performance by 2030”.

Engine No.1, which wants to install four new energy-transition-focused directors on Exxon’s board, was having none of it. In a letter to the board yesterday, it wrote:

“None of the company’s new claims change its long-term trajectory which would grow total emissions for decades to come. This is not consistent with, but rather runs directly counter to the goals of the Paris agreement.”

Exxon did not respond to a request for comment.

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