I recently spoke at the Master Investor Show in London, asking the question: is now the time to Buy British? For those of us of a certain age, this expression is evocative of a patriotic bid to encourage us to buy domestically-produced goods. A similar campaign saw people claiming: ‘I’m backing Britain’.
It sounds quaint now, but truth be told it was already an outdated concept when it was launched in the late 1960s. The decline in British manufacturing had already set in and we were on a path to a service-led, financialised economy and the post-industrial problems that we are still dealing with today.
However, there is one area of British life where we continue to demonstrate a significant home bias. Our stock market portfolios are materially overweight UK shares. Perhaps a third of retail investments are in UK-listed shares compared with a contribution of around 6% to the total market capitalisation of global stocks.
Does this make sense? From a strategic asset allocation point of view, it does not. When you consider that the stock market itself is structurally biased towards developed economies and away from the emerging markets where much of the growth is to be found, our home bias is even worse than it looks at first blush.
From a tactical point of view, however, a case can be made for being overweight the UK. In my Master Investor presentation, in fact, I argued that up to 25% of a portfolio in UK-listed shares could be justified. How so?
Well, the first reason is the relative underperformance of the UK market in recent years. £100 invested in the FTSE 100 in 2014 would be worth just £107 today. That compares with £149 for the same amount invested on Wall Street and £178 in China. Past performance is not a reliable indicator of future returns.
The underperformance has led to a sizeable valuation discount for the out-of-favour UK market. British shares can be bought for around 12.5 times expected earnings. That is cheap compared with other markets, notably the US, and it is cheap when looked at against the historical average.
The other key valuation measure, the dividend yield, also argues for a bias towards UK stocks. The yield of around 4.5% on the FTSE 100 compares with income from UK Government bonds of under 2% and to interest rates of just 0.75%. If we have to wait for some more clarity on the economic and political outlook in Britain, we are at least being compensated in the meantime with a decent income.
Of course, low valuations are not necessarily attractive if the economic backdrop is unsupportive. That is not the case, however. Employment is stronger than at any time since the 1970s and wages are growing faster than inflation again. The public finances are in surprisingly good shape given the uncertainty.
Most importantly, UK companies continue to deliver reasonable earnings growth. In the recent earnings season, around 60% of companies met expectations and 22% exceeded them, according to Goldman Sachs.
Finally, it is worth bearing in mind that while British concerns have soured sentiment towards UK shares, the London market is not really a reflection of the UK economy. Only a quarter of FTSE 100 companies’ earnings are made at home and only half of those in the FTSE 250.
So, the UK remains one of the more attractive destinations for investors today. The bad news of Brexit has been priced in. Its possible resolution has not.
The UK’s improving economic backdrop
Source: Refinitiv/Fathom Consulting, 12 month changes, as at 15.2.19
The value of investments and the income from them can go down as well as up, so you may not get back what you invest. Please be aware that past performance is not a reliable indicator of future returns. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity.
Select 50 recommendations: The Select 50 has a number of good UK funds. As I explain elsewhere, I struggled at the beginning of the year to decide which of these would be the best way to play my positive view of the UK market outlook. The Fidelity Special Situations Fund is an excellent choice for investors who are convinced that the economy will bounce back strongly from the Brexit uncertainty that has clouded the outlook for so long. For more cautious investors, I stick with my preference for Nick Train’s Lindsell Train UK Equity Fund. I am actually happy to own both in my own portfolio. Please note this is not a personal recommendation.
This is a really interesting moment to be invested in the US stock market. Investors are being pulled in two directions, with a newly-dovish Federal Reserve boosting sentiment while trade tensions and the end of the so-called Trump Bump are knocking confidence. At the moment the glass is half full, but the New Year rally feels like it has run its course for now.
The change in the Fed’s approach over the past six months or so has been extraordinary. From steady-as-she-goes tightening to no rate rises and a pause in quantitative tightening in the blink of an eye. The market’s knee-jerk reaction has been positive, but it is just as plausible to wonder whether the US central bank knows something that the rest of us don’t yet.
Our Analyst survey certainly provided some reasons to be concerned about the sustainability of America’s economic and market strength. For the first time since his election in 2016, President Trump has started to be viewed as a negative influence with almost half our US analysts thinking his policies will be a drag, up from only 13% a year ago.
This is a significant swing from the initial optimism about lower corporate taxes, deregulation and infrastructure spending which greeted the election shock just over two years ago. For the first half of President Trump’s first term it paid to give him the benefit of the doubt. He may have failed to deliver all he promised on infrastructure, but tax reform and less red tape have been a positive for investors.
The key driver of increased pessimism is obviously the trade situation, with tariffs expected to weigh on most sectors. Sectors with complex supply chains are the most exposed but the impact is being felt across the market from consumer industries, where higher supply costs are eating into margins, to technology, autos, energy and materials.
With an election to win in 18 months’ time, Mr Trump has an incentive to strike a deal with the Chinese on trade and he will no doubt try to push through some electoral sweeteners over the next year or so. Whether he can do that with the Democrats in control of the House of Representatives remains to be seen.
As for the Fed, while it looks like the will is there to keep stimulating the economy, it is less clear that inflation will give Jay Powell the luxury of inaction indefinitely. With the jobs market as hot as ever, it must surely only be a matter of time before wage inflation starts to be a concern again. If that coincides with a slowing in activity, then the high profit margins shown in the chart may not be sustainable.
The US stock market remains the highest-priced in the world. A case can always be made for that. America is a defensive market and a perceived safe haven for global investors. But the recent recovery of the fourth quarter’s market losses means the tactical reason to buy the US has disappeared for now.
US profit margins remain at all time highs
Source: Refinitiv/Fathom Consulting, as at 23.3.19
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.
Select 50 recommendations: Investors can’t safely ignore the US market. It represents half of global markets’ value and a long-term investor will always want a decent exposure to American shares. But now feels like a good time to be more defensive. Within the Select 50’s North American category, the JPM US Equity Income Fund feels like a safer option in this environment. I would also suggest getting US exposure via a global fund, which can ease back on the US weighting if necessary. The Rathbone Global Opportunities Fund has a higher than average US bias so could be a good proxy for the US for more cautious investors. Please note this is not a personal recommendation.
It is not difficult to paint a pretty gloomy picture in Europe. The latest data out of the region’s engine room, Germany, have been disappointing and the European Central Bank, always cautious, has become even more pessimistic than usual. The upturn in European interest rates looks further away than ever and investors are once again paying for the privilege to lend to the German government.
Like Japan, Europe is vulnerable to any downturn in trade conditions around the world, thanks to its relatively high exposure to exports. The China-led slowdown is clearly not good news.
So why would anyone be interested in investing in Europe? Well, the time to get interested in a market is when no-one else is. Sentiment is now so bad in Europe that for some contrarian investors it’s actually starting to look good. Cumulative equity fund flows in Europe are now at a 15-year low and fund managers have not been so pessimistic about the asset class since the depths of the sovereign debt crisis.
A key development this year could be further stimulus by China. There is a close link (with a lag of a few months) between optimism in China and in Europe. And we are beginning to see an uptick in key sectors like automotive. Also, consumer sentiment remains strong, underpinned by job creation and accelerating wage growth against a backdrop of subdued inflation. In addition to monetary stimulus, all Eurozone countries are expected to implement fiscal boosts this year.
Crucially, after recent outflows, European shares are cheap. Compared with global stocks, they have not been such good value in 50 years. The gap between the dividend yield and bond yields in the region has not been this wide in nearly a century!
It’s worth remembering that Europe is a well-diversified market with a long-list of best-in-class companies. Contrarian antennae should be twitching.
Select 50 recommendation: The Select 50 has a range of growth options focused on Europe, of which the Fidelity European Growth Fund is showing the best recent performance. For income-focused investors looking to pick up that attractive yield differential, we favour the Invesco European Equity Income Fund. Please note this is not a personal recommendation.
Asia and Emerging Markets
The Chinese stock market staged a remarkable recovery in the first quarter of 2019 after a dreadful performance last year. The word on the ground in Hong Kong is that investors came back after the Lunar New Year break with a completely different mindset and the market began to fly. In the short-run shares may pause for breath as many investors’ full year targets have already been hit.
Earnings season will be crucial. 2018 was a tough year on the back of the Trump trade war and numbers are not expected to be great. Investors are looking through these likely disappointments to the lagged impact of new stimulus measures. The only question is whether it has already been priced in.
This is a familiar situation for investors in the volatile Chinese market, so why might things be different this time? Firstly, compared with five years ago when Chinese shares boomed and burst, there is more institutional participation in the market. It is still a retail-led and sentiment-driven market but less so than it was. It is also better regulated.
The other key difference is that Chinese shares are progressively being integrated into the global indices that so much international money tracks these days. When China finally gains its full weighting in MSCI’s indices, A shares will account for more than a quarter of the Asia ex-Japan indices. China will be impossible to ignore.
The other key market in the region is India. This is a very different story. Less volatile than China, and more highly-rated, India looks fully valued, especially after its recent strong run in anticipation of another Modi victory in the upcoming general election. The fundamentals are good in India, but the market is expensive.
China and Japan: changing places
Source: Refinitiv/Fathom Consulting, as at 23.3.19
Select 50 recommendations: Three months ago, we said the Fidelity Emerging Markets Fund had been hit hard by the region’s volatility and was due a rebound. Sure enough, Nick Price’s focus on high-quality companies which he expects to deliver good returns over the medium term has come back into favour as the market has picked up again. This is still a good way of playing emerging markets. We also like the more predictable Stewart Investors Asia Pacific Leaders Fund. Please note this is not a personal recommendation.
The Japanese economy is more exposed to the ups and downs of global trade than almost any other and it has been caught in the crossfire of the US/China battle for economic dominance. Between them, these two giant economies account for nearly half of all Japanese exports.
The swings in, for example, machine tool orders are dramatic and growth in these stands at a multi-year low currently. Unsurprisingly, manufacturers are less optimistic, with purchasing managers’ indices in contraction territory for the first time in over two years. Industrial production data has also rolled over.
The impact can be exaggerated. With consumption accounting for 60% of economic output and exports 20%, the Japanese economy is pretty stable. It is not an emerging market. But the ups and downs of exports can make the difference between growth and retrenchment. The first quarter numbers will therefore make difficult reading.
The good news is that the consumption side of the economy is in good shape. Unemployment is close to an all-time low. The size of the labour force has recovered its mid-1990s high and real, inflation-adjusted wages continue to rise.
The Japanese domestic economy is also getting a significant boost from an explosion of inbound tourism, mainly from China and South Korea. The number of overseas tourists to Japan has grown in less than a decade from around 5 million to perhaps 40 million next year, as the chart shows. Industries like cosmetics are seeing growth of 20-40%.
Add in persistently loose monetary policy and it is not hard to see why inflation is now safely back in positive territory - that’s good news in a country where deflation has tended to be the problem. Assuming that the Government holds its nerve and pushes ahead with a VAT hike to 10% later this year, the upward pressure on prices will continue.
The volatility of Japan’s export sector is reflected in big swings in investor sentiment towards Japan, in particular from overseas. The fourth quarter sell-off was even more pronounced in Tokyo than in other markets around the world. That led to Japan being one of the worst-performing major markets in 2018. So far in 2019 the recovery has lagged too. Unsurprisingly, foreign investors were big net sellers of Japanese shares last year and they are more underweight Japan than when reforming Prime Minister Shinzo Abe was elected in 2012.
The consequence of all this has been a savage de-rating of Japanese shares and they are now almost (but not quite) as out of favour as those in the UK. This is not totally without justification. Earnings estimates have started to decline after a strong three-year upsurge. But it does look to have gone too far. The valuation of Japanese shares is approaching historical lows. When measured against assets (the price-to-book ratio) Japanese shares are around three times better value than their counterparts in America.
Japan can be a frustrating market to invest in. But at a time when markets like the US look vulnerable to an earnings recession and are still highly-rated, Japan’s potential for continuing growth in returns and an undemanding valuation make it feel like a safe haven.
Japan: the new tourist hotspot - overseas tourists by country
Source: Refinitiv/Fathom Consulting, as at 31.12.18
Select 50 recommendations: We make no apology for sticking with our long-standing Japan recommendation, the Baillie Gifford Japanese Fund. Managed by Matthew Brett, this fund is well-placed to capitalise on Japan’s competitive advantages in sectors like automation and robotics. Baillie Gifford has a range of excellent funds and, with long experience in the country, this is one of its best offerings. Please note this is not a personal recommendation.