Global politics dealt equity markets a series of unexpected blows last year, forcing many investors to re-assess their strategies. Uncertainty continues to cloud the outlook for the UK economy, posing significant near-term challenges to equity markets. Principle among these is valuation, with the FTSE All-Share index currently standing at the upper end of its long-term range.
Since 2012, there has been little or no increase in overall earnings but prices have risen, inflating the underlying price-to-earnings multiple. Global equity market valuations have been boosted by the collapse in bond yields, which, without the support of earnings growth, raises questions as to whether current aggregate valuations can be justified.
Sterling weakness since the EU referendum, which has raised the sterling-reported earnings of foreign currency profits, has brought temporary relief from the general trend of downgrades in analysts’ earnings expectations. Consensus estimates anticipate better growth in the aggregate earnings of FTSE All-Share companies, largely attributable to this weakness.
But it is likely earnings growth will come under significant pressure in the coming months, as both the media and Government home in on corporate profitability. Around the mid-2000s there was a step-up in global listed companies’ profits relative to GDP from 1.5 per cent to 3 per cent, with corporate profits benefiting at the expense of a declining share of labour income in GDP.
A more muted backdrop for GDP growth also translates directly into top line revenue growth for companies and I remain sceptical of the abilities of global governments to deliver on their manifesto pledges and drive marked real and nominal GDP growth.
Aggregate earnings growth could become markedly more benign over the coming months as a result of wider market shifts. The trajectory of government bonds and sterling exerted a major influence on UK equities over the course of 2016.
The strong performance of the bond market — which, unusually, has been accompanied by a rising equity market — and the perceived benefit from the drop in sterling have been the driving forces behind the ongoing re-rating of UK equities. A reversal in the long-term downward trend in global government bond yields, or a significant stabilisation in sterling, would remove two of the major drivers pushing UK equity markets higher over recent months.
In the face of these near-term challenges, investors must identify undervalued businesses which can be bought and held for the long-term, which are able to maintain and grow their dividends, and where management views the equity as a precious and rare resource.
Pharma and healthcare
This year has already brought some exciting developments in the pharmaceutical and healthcare sectors. Share price performance of both the large- and mid-cap segments of the pharma sector was disappointing in 2016, leaving investor confidence at a low ebb.
But certain larger companies have an extensive calendar of drug trial read-outs over the next 12-18 months, which will dictate the road map for profit drivers into the next decade.
In the past month, AstraZeneca announced positive results for trials of cancer drug Lynparza, increasing optimism over its ultimate blockbuster potential. Meanwhile, Roche confirmed breast cancer sufferers live longer using its drug Perjeta in combination with biological drug Herceptin and chemotherapy, relative to Herceptin and chemotherapy alone.
Picking the winners in fast moving therapeutic areas such as oncology has become more difficult and many in the market have adopted a more risk averse mind-set. There has also been concern around pricing and political pressures for both existing and new, innovative drugs.
Share prices will continue to react to news flow on drug pipelines but it is important to remember these are well diversified, disciplined companies with strong cash flows and a high degree of discretion over long-term costs, which have the capability to deliver a long-term, sustainable dividend.
In the tobacco sector – which currently trades at a discount to other European staples – the sweeping move to consolidation is driving competition, product development and pricing power among businesses that have delivered high and growing dividends.
Deemed the “logical progression” for both parties, Reynolds American accepted a revised $49.4bn cash and shares offer from British American Tobacco in January, enabling BAT to acquire the 57.8 per cent of Reynolds it does not already own. The merger, due to complete later this year, will create a combined entity well-poised to exploit next generation products and achieve business synergies, particularly in the nascent but rapidly expanding US e-cigarette market.
Mark Barnett is head of UK equities at Invesco Perpetual