The phoney war since the EU referendum has lulled investors into a false sense of security. The FTSE 100 has soared on the back of sterling’s weakness and a surprisingly resilient UK economy. But how long will the honeymoon last?
Many wonder if the stock market can remain close to an all-time high now the clock has started ticking on the Brexit negotiations.
For consumers, the good times may have already passed. Since the vote to leave the EU, the weaker pound has pushed prices higher across the board. The disinflationary environment which has lined the pockets of consumers for the past two years is over. The supermarket price war that kept a lid on food prices is behind us. Fuel costs are no longer falling.
This year, inflation is expected to be near the 3 per cent mark while household earnings are stagnating. With price rises outstripping wages, we are getting progressively poorer each month. This is bad news for an economy reliant on confident consumers hitting the shops.
Meanwhile, markets are susceptible to persistent volatility as we muddle through the next two years of difficult negotiations.
A point often made is that the UK stock market is a very different beast from the UK economy, benefiting from many global companies. The silver lining to a weaker pound is that it makes our goods and services more competitive and the overseas earnings of UK companies more valuable on translation back into sterling.
For income investors, there’s an obvious advantage here too. Currency swings can make a big difference to the dividend payouts of the big blue-chips as many of these multinationals declare their income payments in dollars.
Despite billions of pounds of dividend cuts from some of the UK’s largest companies in 2016, and zero growth for many more, the alchemy of exchange rate gains following the pound’s post-referendum tumble turned a leaden year into a golden one. According to the latest Capita Dividend Report, £4.8bn of the £5.2bn headline increase in dividends in 2016 was due to sterling’s weakness.
Many professional investors are taking advantage of the global nature of the UK stock market by tilting their portfolios towards international names in the oil, mining and engineering space as a buffer against uncertainty. Leigh Himsworth, who manages the Fidelity UK Opportunities Fund, for example, has increased exposure in names like Glencore and BHP Billiton. Both companies took the scalpel to their dividends in 2016, but the rebound in commodity prices last year could bode well for dividend growth.
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Looking at the UK stock market more broadly, income investors are spoilt for choice. According to the Digitallook website, 15 FTSE 100 shares currently yield more than 5 per cent. A further 13 companies yield more than 4 per cent. That means nearly a third of the blue-chip index offers an income of more than 16 times the Bank of England’s base rate and more than twice what you might earn from a 10-year government bond.
Of course, the higher an apparent yield is, the greater the chance that it will not actually be delivered. Question marks remain over how long the currency effect can prevail if Brexit means a slowdown in the broader economy.
Perhaps more pertinent is the need to adjust portfolios for the inflationary environment created by the weak pound. Inflation is a “Jekyll and Hyde” character. It chips away at the value of money. That’s good news for borrowers as it means a fall in the value of their debts, but it also erodes the spending power of future interest and dividend payments.
That said, an increase in inflation from a very low level is not necessarily a bad thing. Equities can perform well in the early stages of reflation. The financial sector is an obvious winner. Higher inflation will force a rise in interest rates which is positive for banks because they make money on the difference between the rate they charge on the loans they make and the interest they pay on deposits. That’s why a number of fund managers have recently topped up on names such as HSBC.
Food retailers are another interesting hedge against a newly-inflationary backdrop thanks to how the cash cycle in their business works. We may buy a tin of beans today at a certain price, but the retailer only pays the supplier 60 days later at the old price. As consumers, we don’t know which goods are susceptible to inflation, which means retailers can sneak through price rises across the board. Marmite-gate was a clear warning that price rises are the new normal.
Inflation also bodes well for highly-geared companies. As debt tends to be fixed, a business’s borrowings will be eroded as inflation takes off. If the business generates positive free cash flow, so much the better. Even with no change in the overall enterprise value of a company, all investors need is for the balance to move from debt to equity to make a significant gain. Tesco ticks both the food retailer and high debt boxes. J Sainsbury comes with an attractive dividend yield of over 4 per cent as well.
More broadly, it is worth seeking out companies with pricing power — strong, niche players with the ability to push through price rises regardless of what’s happening in the broader economy. Fund manager Himsworth lists the likes of Ricardo, a global engineering, environmental and strategic consultancy, listed on the FTSE All Share.
History shows there has been a sweet spot in the inflation range that suits equities well — normally at about 2 to 2.5 per cent. UK inflation is now bang in the middle of that range at 2.3 per cent. Of course, the problem is when rising prices become entrenched. If inflationary pressures and rising borrowing costs start to squeeze real incomes and hamper corporate investment, equity markets get worried.
So for how long can UK investors play the reflation trade? Two key markers to watch are UK bond yields moving above 2 per cent or the trend in Consumer Price Inflation nudging towards the 3 per cent “top limit”.
It is also worth keeping an eye on company statements — any comments in the fine print that the business has been unable to pass through rising input costs should start to flash amber warning lights. We are probably nearer the start than the end of this process, and the astute investor can still benefit. But this calls for a paradigm shift from the “lower, for longer” investment mantra we’ve followed over recent years.