FTSE 100 loses earnings momentum again

Brexit continues to dominate the headlines as the 31 October deadline for a withdrawal by the UK draws near and equity, bond and currency markets are becoming more volatile as a result. The dangers of second-guessing the outcome of the talks between Britain and the EU are clear from how the FTSE 250 index soared by more than 800 points, or 4%, one day (11 October) only to shed more than 200 points during the next trading session (14 October) as hopes for a deal rose and then fell. Sterling made big gains and then losses, too, while the yield on the 10-year Gilt rose from 0.46% to 0.71% in a single day before falling back.

Given that no one – not even the politicians involved in the talks – knows what is going to happen, it would be very brave of advisers and clients to try to second-guess and trade on the outcome.

Narrative does not determine investment returns. All advisers and clients can spot a good story and swerve a bad one. Rather, it is the price paid and the valuation accepted to access the profits, cash flows and dividend stream of an index in aggregate, a sector in total or a specific stock that is the ultimate arbiter of investment returns.

Price must be right

“The good news is that it is possible to make a case for UK equities being cheap, especially after a period of underperformance on the global stage that predates the summer 2016 EU referendum vote by some distance.”


The good news is that it is possible to make a case for UK equities being cheap, especially after a period of underperformance on the global stage that predates the summer 2016 EU referendum vote by some distance. Over the past 10 years, the UK stock market, as benchmarked by the FTSE All-Share, has provided a total return in sterling terms of 104%.

That lags not just the rip-roaring US equity market, but also Japan, Asia and even Western Europe as well (with sterling’s decline playing a part). UK equities have outperformed only emerging markets, not developed ones.

UK equities have lagged developed market alternatives over the past decade

Source: Refinitiv data. Total returns in sterling terms since 1 January 2010.

As a result of this moderate showing, it can be said that UK equities look cheap relative to their international peers and to their own history on just 12.7 times forward earnings for 2020, with a dividend yield of 4.6%. That dividend yield in particular may catch the eye of income-seekers, as it is the highest figure on offer from any of the eight major geographic equity market options and represents a premium of more than 400 basis points (or four percentage points) relative to the benchmark 10-year Gilt yield.

UK equities are looking cheap relative to other geographic options

Source: Bloomberg data

Such an enormous yield differential could support the There Is No Alternative (TINA) argument when it comes to equities, relative to bonds (or even cash). Yet advisers and clients then need to ask themselves: are the earnings and dividend forecasts which underpin those tempting valuation metrics any good?

“Advisers and clients then need to ask themselves: are the earnings and dividend forecasts which underpin those tempting valuation metrics any good?”

Numbers game

The good news is the aggregate consensus analysts’ forecasts for 2020 do not look unduly aggressive. Looking at the FTSE 100 alone (and this represents some 85% of the UK’s market cap), analysts’ estimates are calling for:

  • revenue growth of 2%, to an all-time high of £1.85 trillion

  • pre-tax profit growth of 8%, to an all-time high of £238 billion

  • dividend growth of 3%, to an all-time high of £95.1 billion (even excluding special dividends)

  • Granted, if the UK economy slips into an unexpected recession, and is joined there by, say, the US, then such figures are likely to prove wildly optimistic. Equally, the numbers could prove to be too low if the British and global economies prove more resilient than the current consensus amongst analysts and economists would have us believe. And the trio of all-time highs would lead investors to ask why the FTSE 100 is still trading some 8% below its May 2018 closing peak of 7,877.

    “Aggregate earnings estimates have begun to slip a little for 2019 and 2020. […] By contrast, dividend estimates are still sneaking higher.”


    The issue is perhaps that investors are wary of the reliability of the forecasts. Unfortunately, we can see how aggregate earnings estimates have begun to slip a little for 2019 and 2020, as downgrades at the banks outweigh upgrades at the miners:

    FTSE 100 earnings forecasts are stalling again

    Source: Company accounts, Sharecast, consensus analysts’ estimates

    By contrast, dividend estimates are still sneaking higher. That offers some encouragement but you do have to wonder how long that trend can continue if profit forecasts are leaking lower at the same time.

    FTSE 100 dividend forecasts are still rising

    Source: Company accounts, Sharecast, consensus analysts’ estimates

    Conclusion

    The absence of profit forecast upgrades does leave the UK equity market bereft of one possible catalyst for performance. But someone, somewhere, still thinks the combination of lowly earnings valuations, a fat yield and a depressed currency offers some value, judging by the rash of bids for quoted UK firms from foreign rivals. Sophos is just the latest example after ARM, Sky, Punch Taverns, Premier Farnell, Brammer, Greene King and many more beside. If overseas captains of industry think there is value to be had, perhaps advisers and clients should at least ponder why that may be.

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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