Why Brexit is bringing unexpected benefits to UK equities (at least for now)

Taken in aggregate, profit and dividend forecasts can give a feel for whether one equity market looks cheap or expensive relative to another, or relative to its own history. In addition, momentum in aggregate earnings dividend forecasts can help to shape sentiment toward a particular market, at least in the short term – in its crudest form, rising forecasts and better-than-expected earnings can lead to rising markets (even where valuations look full), and falling profits and worse-than-expected corporate reports can lead to falling ones.

The UK looks to be a classic case in point. Every quarter, after the FTSE indices’ latest reclassifications and constituent changes, AJ Bell updates a model with aggregate sales, earnings and dividend forecasts for the FTSE 100.

The latest revision comes three months after Brexit and three themes spring out from the numbers:

  • First, earnings estimates are creeping higher for 2017, a trend which has not been evident for the past two years.
  • Second, dividend estimates are creeping higher for both 2016 and 2017, again a welcome reversal of the downward trend evident since the start of last year.
  • Third, at current levels (around the 6,800 mark) the FTSE 100 offers a yield of 3.8% for 2016 and 4.0% for 2017. Both figures look attractive relative to cash and UK Government bonds, but the risks are higher because dividend cover is thinner than ideal, even if higher earnings are helping here. A breakdown of the numbers shows which sectors and stocks really matter when it comes to future earnings and dividend growth. Advisers and clients may not have time to research those names but they can at least keep an eye on them and what their preferred fund managers think about them when they meet.

None of this is a guarantee for the future, as other factors must be considered, especially interest rates – low returns on cash and bonds have provided support to the FTSE 100 even as earnings and dividend estimates have dribbled lower over the past 18 to 24 months.

That pattern of downgrades may help to explain why the FTSE 100 has gone nowhere fast since it set a new high of 7,104 in April 2015 and a series of upgrades would be welcome and is frankly probably needed if the UK’s premier index is to challenge its prior peak.

FTSE 100 still trades below the April 2015 all-time high

Source: Thomson Reuters Datastream

The new rush of forecast upgrades is welcome but it is too early to say whether the Brexit storm has been weathered or not – partly because Brexit has not happened yet and partly because the bulk of the upgrades to dividends so far looks to have come from the pound’s plunge against the dollar and the euro, a decline which has increased the value of the FTSE 100’s overseas earnings.

If advisers and clients do wish to embrace this new-found positive momentum, in the knowledge that Brexit, interest rate and other risks remain, there are at least plenty of options available when it comes to active or passive funds.

By way of example, the three tables below list the top-performing funds, investment trusts and Exchange-Traded Funds (ETFs).

Best performing UK Large-Cap Blend Equity OEICs over the past five years

Source: Morningstar, for UK Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Best performing UK equity investment companies over the last five years

Source: Morningstar, The Association of Investment Companies, for the UK All Companies category
* Share price. ** Includes performance fee

Best performing UK Large-Cap Blend Equity ETFs over the past five years

Source: Morningstar, for UK Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Momentum shift

In the long run, equity valuations are driven by profit and cash flow, so in some ways the FTSE 100 has done well to hold up as well as it has.

Each quarter AJ Bell takes the consensus forecasts for all 100 members of the benchmark and then aggregates them to provide a picture for the headline index.

The chart below shows the quarterly trend in total pre-tax profit forecasts for the FTSE 100 – remember that it is only by the middle of the following year (say June 2015 with regard to calendar 2014) that the final results will be largely known.

The trend is clear enough – forecasts have ground consistently lower for 2014, then 2015 and 2016, weighed down in particular by the miners and the oils (which are in turn suffering from weaker raw material prices), and also the banks and insurers, where record-low interest rates are hurting operational profits. In the case of the banks, regulatory woes and fines have not helped either:

Analysts are upgrading UK plc earnings forecasts for 2017

Source: Analysts consensus estimates, Digital Look, Thomson Reuters Datastream

The good news, however, is that estimates for 2017 have ticked up over the past three months, in a welcome change of momentum.

If this becomes a trend it could provide support to the FTSE 100 but advisers and clients need to tread carefully here for three reasons:

  • First, a lot of the upgrades are coming from overseas earners and dollar-sensitive plays – miners, oils and pharmaceuticals in particular. The pound has fallen since the June EU referendum vote to provide a windfall but relying solely on forex movements is low-quality stuff, especially as currencies can quickly reverse trend.
  • Second, three-quarters of analysts’ aggregate pre-tax profit growth forecast for 2017 (a leap of some £42 billion to £177 billion) comes from just three sectors – Oil & Gas Producers, Mining and Financials (banks and insurers).

Three sectors dominate 2017 FTSE 100 growth forecasts

Source: Analysts consensus estimates, Digital Look, Thomson Reuters Datastream

Advisers and clients may not have time to track all of the individual names here but at least they now know the questions to ask and areas to target when they meet fund managers.

Dividend growth

Another source of support for the FTSE 100 has been its dividend yield. Forecast yields of 3.8% for 2016 and 4.0% for 2017, based on an index level of 6,800 and the bottom-up total of consensus forecast dividends for all 100 companies in the index, may tempt income-hunters, given paltry returns on cash and skinny Government bond yields – albeit in the knowledge there is greater capital risk with stocks.

The good news is that the same trends that are helping earnings – weak pound, strong dollar, improved commodity prices – are helping dividend forecasts for 2016 and 2017. After a rotten run of downgrades, analysts are nudging up shareholder payout forecasts, to the extent that total FTSE 100 distributions are seen rising by 8% this year and 5% next, to £72.8 billion and £76.6 billion respectively (excluding special dividends).

FTSE 100 dividend growth forecasts for 2016 and 2017 are moving up

Source: Analysts consensus estimates, Digital Look, Thomson Reuters Datastream

Take cover

The problem here is that earnings cover of those dividend payments is thinner than ideal. In a perfect world, dividend cover should be at least 2.0 times, to allow margin for error in the event of an economic downturn or full-blown recession.

At least earnings forecasts are now rising faster than dividend forecasts and cover is now 1.66 times for 2017, up from 1.34 times in 2015, according to aggregate consensus analysts’ forecasts.

FTSE 100 dividend cover is improving but still too thin

Source: Analysts consensus estimates, Digital Look, Thomson Reuters Datastream

No-one should be too complacent here, as 1.66 times cover is still lower than it should be. But at least the dividend growth forecasts have a better balance to them than earnings forecasts, with Financials (Banks and Insurers), Consumer Staples, Consumer Discretionary and Industrials leading the way.

Forecast FTSE 100 dividend growth has a broader base than the earnings growth forecasts

Source: Analysts consensus estimates, Digital Look, Thomson Reuters Datastream

Fresh start

Ultimately it is a welcome change to see estimates rising rather than falling and it will be interesting to see if this momentum can be maintained.

The Bank of England seems unwilling to rock the boat with interest rate rises but the actual implementation of Brexit remains an unknown and relying on currency weakness alone is unlikely to work forever – sterling rebounded pretty quickly after its 1992 devaluation as the economy shot out of a recession on the back of the benefits and the World Trade Organisation’s cuts to global trade growth estimates for 2016 and 2017 make sombre reading.

Brexit may be bringing unexpected benefits to multinationals’ earnings, but for corporations and politicians alike, the real work has yet to begin.

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.