Richard Buxton: Mind the valuation gap

Buxton Richard Old Mutual

We are nearing the end of another year overshadowed by the “will they, won’t they?” debate around US interest rates. Next year will continue to be dominated by interest rate policy, even if the question now becomes “how high, how quickly?”. The concern about the strength of the global economy is not going away any time soon.

Thanks to the impact of slower growth in China and other emerging markets, plunging commodity prices, and massive retrenchment by oil and mining companies and all those touched even tangentially by their behaviour, industrial activity is weakening. Profit warnings and earnings downgrades from industrial companies worldwide abound, with manufacturing surveys pointing sharply south.

By contrast, most service sector surveys are still pointing firmly upwards. Developed world consumers are benefiting from robust labour markets, modest income growth and lower fuel and energy costs. A key question for 2016 is whether the industrial weakness will infect broader corporate sector confidence, undermine the strength in job creation and sap consumer appetites.

If so, US rates are hardly going up at all. But then neither are corporate profits or, probably, equity markets.

If, on the other hand, the industrial weakness turns out to be a one-off adjustment to a lower level of demand from China and resource companies – exacerbated, as ever, by an inventory cycle – the surprise for next year could be that the resilience of the consumer and services sides of Western economies more than offsets manufacturing weakness, and growth is steady if unspectacular.

The degree to which investors are split into two camps of “growth” versus “no growth” is evidenced in the ever-widening gap between the valuations of those companies offering a reasonable certainty of growth and any company where there is uncertainty about the outlook. Investors are so scared, they will pay higher and higher valuations for “growth” and refuse to abandon that which is working for anything which currently is not.

Value stocks, recovery stocks, commodity stocks, mega-cap stocks – if it does not have positive earnings momentum, investors just do not want to know. Mean reversion? Relative value? There is no appetite whatsoever to catch a falling knife.

While mindful that trends can go on for longer than anyone anticipates, if growth does muddle along in 2016 rather than anything more sinister, then surely at some point investors will become a little less fearful. In a more normal economic cycle, as central banks begin to raise interest rates from recovery levels, cyclical and value shares tend to perform well as beneficiaries of economic growth. Premiums for defensive stocks unwind. In this long, drawn-out post-crisis healing cycle, the same should be true eventually.

And while I fully expect any journey towards higher levels of interest rates and bond yields is going to be an equally protracted multi-year process, this will, over time, be helpful to financial stocks. For years now they have faced the headwind of rock-bottom interest rates and ever-declining bond yields. Slowly, this should turn into a modest tailwind.

Meanwhile, the Bank of England’s recent pronouncements on bank capital really do indicate we have reached a turning point. The regulator has flagged that UK banks have sufficient capital or will have through planned capital generation over the next few years. No more worries over equity capital raising. The move towards higher dividend payments to shareholders can now begin in earnest.

Bank shares, shunned by investors for so long, can really start to appeal once more. And again, the premiums paid for growth stocks with commensurately modest dividend yields must surely come into question if yields offered by banks are set to rise sharply.

Richard Buxton is head of UK equities at Old Mutual Global Investors