Opportunities in the Uncertainty

Beaufort Securities Special Report

By Mike Franklin, Chief Investment Strategist

‘If you can keep your head when all about you are losing theirs and blaming it on you’
from the poem ‘If’ by Rudyard Kipling, published in 1910.

The insights into the human condition by Rudyard Kipling of ‘Jungle Book’ fame seem to be particularly relevant to the present moods and condition of investment markets. When there are so many countervailing trends, both private and professional investors might be forgiven for an element of confusion demanding of a cool head. There is an overwhelming need to be able to cut through the noise and to ignore what may prove to be irrelevant. So, what are the issues facing investors as we approach the end of the turbulent first quarter of 2016 with the FTSE 100 Index, after all the fuss, only marginally changed year-to-date?

Globally, the slight slowing in the rate of economic growth evident towards the end of last year has continued into 2016, reflecting in particular reduced growth in China as well as negative trends in net oil exporting countries such as Russia and Venezuela on the fall in the crude oil price. Despite some recovery in recent months, a declining trend over several years for raw materials such as iron ore and copper have impacted Latin American countries, including Brazil, Argentina and Mexico.

The OECD (Organisation for Economic Co-operation and Development) recently reduced its forecast for US GDP from 2.5% to 2.0% against last year’s 2.4%. Meanwhile, despite the easy money policies of the European Central Bank, the economies of the Eurozone cannot be described as thriving, with the obvious exception of Germany. As this week’s UK Budget revealed, the challenge for the Chancellor to balance the books by 2020 is growing as the tax take shrinks on slowing economic growth and, now, the need to back-track following the resignation of Work and Pensions Secretary, Iain Duncan-Smith. The OBR (Office for Budgetary Responsibility) has revised down its growth forecast for UK GDP growth from 2.4% made just in November 2015 to 2.0%. In February, the OECD’s cut its November 2015 estimate for global growth in 2016 of 3.3% to 3.0%. This revised rate of change is the same as that achieved in 2015.

Consequently, it is evident that the global economic background is not helping markets to move much higher at the moment. However, the prospect of higher interest rates seems to be receding by the day. The US Central Bank, the Federal Reserve, would like to be able to raise interest rates again soon but its efforts are hampered by the domestic slowdown, low inflation and concerns about the rest of the world. Indeed, the latest meeting of the Federal Open Market Committee concluded that there might now only be two interest rate rises in 2016. June is now favourite for the next increase after the maiden rise in December 2015.

This scenario, coupled with the seeming inability of the European Central Bank to inject lasting impetus into the Eurozone economies (or, indeed, for the Bank of Japan to reinvigorate the Japanese economy), undermines investor confidence that Central Banks are adequately equipped to tackle global challenges. In the UK, the situation is compounded by a not inconsequential wrinkle, the European Union Referendum (EUR).

The EU Referendum (EUR)
It is not the place of broker research to try to influence readers’ views on how to vote in the June 23rd referendum. However, some assessment of the key features may be helpful to our clients in forming an investment view and it is to be hoped this can be achieved without encountering the sort of hostile reaction recently faced by the Bank of England Governor, Mark Carney.

Indeed, the mood around the EUR debate so far has been febrile and, given that the government is so acrimoniously split over the issue at the highest levels, it is a moot point whether the EU issue is suitable for the public to decide in a referendum. Anyway, we have another three months to the vote and investment decisions still need to be made.

In its simplest form, we have two mutually exclusive stances in what is, in reality, an extremely complicated matter at all levels, given the vested interests involved. For many of the ‘Out’ campaigners, the issue centres on self-determination for the UK. Sovereignty should be non-negotiable and the EUR provides an unexpected opportunity to turn back the clock. Even if there is some economic disruption, it is regarded as a price worth paying for the economic and political freedom that they believe would be gained.
At the other extreme, the ‘Ins’ focus on the disruption to existing trade that they believe Brexit would create. Understandably, if you have invested much time and money developing your business with the European Union, you may not be prepared to put that at risk. Will the EU still wish to trade with Britain to the extent that it has in the past? How long will it take for new Free Trade Agreements to be negotiated? How will the rest of the world react?

Just the fact of having the Referendum has already made itself felt. The expectation that interest rate increases would come in the US ahead of in the UK weakened Sterling against the dollar by around 13% since mid-June 2015 but the rate of decline accelerated after mid-December 2015 ahead of the Referendum date being announced last month. This could be dubbed a ‘Referendum Uncertainty Discount’ although it does provide a short term boost to exporters whilst stimulating inflation. Also reflecting the rise in uncertainty is the evidence of a fall in the levels of new business investment and capital commitments as investors hold off until the situation has been resolved.

It is perhaps worth noting here that, although the possibility of Britain leaving the European Union appears to have been partially discounted, some observers expect further Sterling weakness in the event of an exit vote. The generally-accepted time required to unwind the UK’s link with the EU is taken to be about two years. During that time, the UK would need to recover its former trading relationships with the EU as far as it could while establishing links with a broader range of non-EU trading groups. As the new trading picture crystallizes, Sterling could be expected to rally strongly.

With just under another fourteen weeks left until the vote is held, the current state of play seems to be that the EUR is for the ‘Ins’ to lose given their advantage of being the incumbent and the real possibility of voter inertia. However, last year’s Scottish Independence Referendum showed how quickly things can change and nothing should be taken for granted. As described above, there will two hardened, irreconcilable, extremes – those wanting to reclaim full sovereignty at any cost and those more interested in avoiding any economic disruption regardless of the sovereignty issue – and they probably don’t cancel each other out numerically. At the time of writing, it is far from clear what will drive the centre ground except particular self-interest and, perhaps, the fear of any change, however irrational that might be.

The Investment Choices
For investors into the UK equity market, the Brexit debate is adding another layer of uncertainty to a market already in a state of flux. Formulating investment decisions is likely to be even more difficult in the next few months. Even the proactive short term trading approach can be thwarted when share prices move sharply in only narrow ranges, as has been the case for much of March so far.
The likely impact of the EUR outcome on Sterling has been mentioned already but the implication for the UK equity market looks likely to be more nuanced as any Sterling dollar weakness will generally benefit non-EU-oriented companies while EU-reliant companies will reflect the threat to trading prospects implied by a possible Brexit, even if these prove eventually to have been overstated. Meanwhile, the prospect of loose money conditions in the UK and elsewhere can be expected to persist as a counter to slowing growth and residual concerns about Deflation.

In UK equity market terms, the net result of these factors is likely to be more of the choppy conditions that we have been experiencing in the past few weeks as a consistently dominant market trend fails to emerge in the face of investor uncertainty. Market sentiment remains heavily influenced by the volatile trends in the prices of raw materials such as oil, iron ore and copper, particularly given the significant weighting of these sectors in the FTSE 100 Index.

For investors, it is time to review portfolio liquidity levels depending on how comfortable they feel in the face of all the points discussed here. The level of equity exposure is, of course, subject to individual personal financial objectives and cannot be considered here. Clients choosing to increase their investment exposure can decide whether to be aggressive by making lump sum purchases immediately or to be more defensive by drip-feeding new money into the market over the next few months. The following guidelines are suggested for clients taking a one-to-two year view.

Investment Strategy Portfolio cash weighting
Aggressive 0% – 10%
Moderate 10% – 20%
Defensive 20% – 30%

Selecting stocks for a portfolio on a one-to-two year view is quite challenging in the face of doubts about future earnings prospects. The following constituents of the FTSE 350 Index have been identified as potentially offering a high level of sustainable dividend income although there can be no guarantee that dividend payments will not be cut. The presumption is that, even if dividends are trimmed back, the yields on these stocks will still be amongst the highest in the FTSE 350 Index and this will provide some stability during the inevitable phases of market volatility in the next one to two years.

Current price (p) Market Value (£’M) Indicated Gross Dividend Yield (%) Earnings to Dividend Cover (X)
Berkeley Group
3,212.00
4,325
6.67
1.73
British Land
708.50
6,865
4.23
6.13
Carillion
306.60
1,290
6.30
1.69
Galliford Try
1,439.00
1,158
5.52
1.65
HSBC Holdings
453.00
88,526
8.09
1.29
Interserve
458.60
623
5.87
1.95
Legal & General
241.00
13,831
5.64
1.47
Royal Mail
475.00
4,760
4.97
1.55
Vodafone
216.60
57,259
5.82
1.92
TOTAL
53.10
Average
(for 9 positions)
5.90
Data from Bloomberg as at 21st March 2016

It should be noted that these stocks have been selected primarily for yield and may not necessarily be recommended as longer term fundamental ‘buys’ by the Beaufort Research team in our other research vehicles, such as ‘Breakfast Today’. This should not be regarded as inconsistent as the team may be applying other investment criteria.

Other recommendations by Beaufort Securities which clients may wish to consider are those covered by Beaufort’s ‘Tips for 2016’ publication. Released in January, it is expected to be reviewed shortly after the quarter-end.

Meanwhile, we continue to apply our technically-based screening approach to identify short term investment trading opportunities – both to sell and to buy – for our Advisory Clients through our team of Investment Advisors.

Unusual market conditions require careful handling and when, as now, the outlook for markets is especially hard to nail down, it is appropriate that individual investors attempt to see their decisions in a broader context. It is hoped that the review of current issues here will help with that process.

Mike Franklin Chartered FCSI
Chief Investment Strategist

RISK WARNING

The information does not constitute advice or a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. You are recommended to seek advice concerning suitability from your investment advisor. Investors should be aware that past performance is not necessarily a guide to the future and that the price of shares, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. There is an extra risk of losing money when shares are bought in some smaller companies including “penny shares”. There can be a big difference between the buying price and the selling price of these shares and if they have to be sold immediately, you may get back much less than you paid for them or in some circumstances, it may be difficult to sell at any price. It may also be difficult for you to obtain reliable information about the value of this investment or the extent of the risks to which it is exposed. Where a company has chosen to borrow money (gearing) as part of its business strategy its share price may become more volatile and subject to sudden and large falls. This type of investment may not be suitable for all investors, and you should carefully consider your own personal financial circumstances before dealing in the stock market, particularly if on a fixed income or approaching retirement age.

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