December 2011
The big call – now is the time to buy UK equities
Next year the Office of Budget Responsibility forecasts that the UK government will pay £47 billion in interest to its creditors. According to our data all the companies in the FTSE 350 will pay out £76 billion in dividends in 2012.
Ignoring any changes to the capital value behind these income streams it would be logical to argue that a typical UK investment portfolio would mirror this split. On that basis the split would be roughly 40% in gilts and 60% in UK equities. Indeed, that is probably a close approximation to many portfolios, whether private or institutional. However, if we start drilling a little deeper we see things are not that simple. We know 40% of UK shares are held by overseas investors so the UK as a whole must be underweight UK equities. That means it might have foreign shares to make up the difference or, more likely, they are overweight in bonds, especially gilts.
All of us are familiar with the trait of running your winners and either grimacing at, or selling, the losers in a portfolio. After the near twenty year bull market in gilts and eleven year bear market in equities it would not be surprising to see most portfolios are now overweight in gilts. Despite the economic storms gilts have been a surprisingly safe haven and have rewarded their owners with impressive capital gains. Moreover, surveying the international scene it is hard to identify a foreign debt market that looks either safer or offers better value. Whatever happens with the actual notes and coins the divergence in European bond markets has already demonstrated that the concept of a single European currency has failed. Sovereign euro debt is no longer equal and it can only be a matter of time before the realisation that not all euros are equal becomes widespread. There is now significant risk of full or partial sovereign defaults.
If you can’t trust politicians to pay their debts who can you trust?
Apparently moneylenders of old always charged kingdoms more to borrow than fellow merchants. After all, they could always claim their goods in the event of a default or have the miscreants slung into jail. It wasn’t so easy to use such methods on a recalcitrant king.
Maybe the time has come to go back to those valuation standards. Although as a working assumption it is wise to treat all corporate executives with caution they are at least, generally, working for shareholders and their interests are aligned. That is often not the case with politicians who can easily direct voter anger towards sovereign lenders as the cause of their problems.
It is true that the outlook for UK debt is better than for some other countries because it still controls its own currency and interest rates. But the economic situation remains dire and the Autumn Statement from the Government predicts that the stock of UK debt will rise from its current level of £1,044 billion to £1,515 billion by 2017. In other words the gilt market is going to expand by 50% in the next five years.
Investors might welcome this development as the Government will have to increase its interest payments to £65.5 billion. Lenders are going to receive a lot more income. There is, though, one fly in the ointment. Usually, when the supply of a good or service increases its price goes down. How will lenders react to a 50% increase in the stock of debt and will 10 year gilts still only yield 2% in 2017?
Of course the outlook for equities is clouded by the poor prospects for the world economy and it would be a brave analyst who forecasts rapidly rising profits. Even so, that diverse income stream from the 300 companies in the FTSE 350 is sourced from all over the world and, in aggregate,is probably pretty reliable. Indeed, it is possibly safer than a number of foreign sovereign bond markets. While there is frequent angst about the inclusion of overseas stocks into the UK market it has enabled this exchange to expand, typically with resource exploitation in emerging markets. These activities usually have higher margins, and hence better cash flow, than mature metal bashers in developed economies that face brutal competition. Even if the dividend stream does not rise much, the compounding effect of that cash flow will benefit shareholders in the same way it has done for the last 100 years. It is those cash returns, not capital growth, that have provided equity returns to shareholders.
The best thing UK investors, as a group, can do now is buy back the UK equities they have sold to foreigners over the last few decades. They need to secure that income for themselves before overseas investors realise how valuable it is.