As Wall Street notches up new record highs with monotonous regularity, the UK stockmarket remains firmly stuck in a trading range, with seemingly no appetite to make an assault on the old high of 15 years ago at just below 7,000 on the FTSE 100. Far from any sense of euphoria or irrational exuberance among investors, the mood is strangely subdued and cautious.
In part, this is because most equity managers, myself included, are underperforming the index this year, after two years in which active managers handsomely trounced passive funds.
In the massive sector and size rotation that is under way, popular cyclicals, mid- and small-cap stocks have suffered profit-taking and unloved mega-cap sectors such as oil and pharmaceuticals have dominated a pretty concentrated leader board.
At the time of writing, only a quarter of the FTSE 100 stocks were beating the index. Lagging the market, if only by modest amounts, is not a recipe for inducing euphoria among fund managers.
But that is not the only reason for such a downbeat mood among UK equity investors. Equities have doubled since the lows of the financial crisis. The ‘bargain basement’ valuations of 2009/10 are few, with the market P/E ratio very much in line with its long-run average of around 14 times.
We need to see corporate profits growing ahead of expectations and upgrades to forecasts, but in aggregate this has yet to happen across the market. Strong sterling is eroding profits growth for many multinational companies, while revenue growth is still sufficiently modest for many domestic stocks that significant positive surprises are rare. It is unlikely the half-year results reporting season that is about to get underway will change this picture materially.
Survey after survey suggests corporate sector confidence is increasing – and rising employment and job vacancies support this view. But in a world of excess capacity relative to demand for almost anything apart from oil, companies remain reluctant to increase capital spending.
Competition is fierce and pricing frequently under pressure – ask any food retailer. Swathes of industries are having to adapt to the digital world, which can of course lead to efficiencies and productivity gains but equally can require substantial changes to operating models, advertising, routes to customer and pricing. It can cost money, with uncertainty as to the returns, but it is money you have to spend or someone else will take your customers.
Meanwhile, the UK economy is sufficiently strong that the Bank of England has started to steel people for a rise in interest rates. This, of course, is always a tricky and volatile time for equity investors and often associated with the kind of rotation to large caps and less cyclical stocks that we are experiencing this year.
In 2004, when the US Federal Reserve started to raise interest rates as the recovery from the tech bust gained strength, many cyclical shares in my portfolio fell heavily as investors rotated away from them. But it was far too early into the expansion to call time on their growth in profits and they all rallied to new highs in 2005 and beyond.
This is instructive, and in my view one should guard against too knee-jerk a reaction to the turn in the interest rate cycle for domestic cyclical shares. Retailers and housebuilders responded in Pavlovian style to Bank of England governor Mark Carney’s recent warning about the time for interest rate rises looming with sharp falls. But in my view the economic backdrop for these sectors will remain extremely positive for the next two to three years or more, firmly underpinning further growth in profits and dividends and making many shares too cheap. This is a time for patience and a steady eye on the medium term rather than over-sensitive hyperactivity in your portfolio.
There are two worrying developments to watch. First, obviously, is the risk of an oil price spike as a result of the insurgency in the Middle East, where it really does look as if the existing post-war national boundaries are being redrawn. Several times in recent years oil has risen above $120 a barrel – and the world slows as a result. We are perilously close to this level again.
Second, while there is precious little euphoria among equity investors, there is plenty of it in the debt markets. The ‘reach for yield’ is seeing debt issuance by fairly dubious credits at yield levels that any long-term rational analysis would deem rather generous, to put it politely.
‘Cov-lite’ issuance is back to the levels of 2006/7, which surely raises alarm bells about defaults and losses for someone some way down the road. This does feel like a bubble waiting to burst.
But in UK equities, we are far from euphoria and exuberance. Which, of course, is quite bullish.
Richard Buxton is head of UK equities and manager of the Old Mutual UK Alpha fund