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2020 has seen the equity valuation gap widen between US v. Rest of the world (RoW.)
There are 4 major reasons for high US valuations:-
a) Expectations of persistently low Fed funds – the FOMC has said it will ignore higher inflation and keep ultra-low interest rates to 2023. The Fed stance has reduced the attractions of fixed income and cash.
b) Resilient US profitability – S&P 500 forecast EPS at $116.77 for 2020 is 17% below 2019 – similar to Q1 2018 earnings, and above S&P’s 2017 EPS at $115.49. The 17% profit drop is far better than RoW. According to Refinitiv data- Eurostoxx Q2 2020 earnings fell 67.5%.
c) Higher representation for US techs in leading indices, high US tech profit growth and high US tech profit share as a percentage of the overall US market. This compares to low tech representation in RoW. The US tech sector’s profitability is the major source of US investor returns, though this factor is not new to 2020.
d) C-19 has led to a repatriation of funds back to the US from RoW. This is partly attributable to worsening Sino-US relations, global trade tensions, “Brexit” and C-19 damage to RoW GDP prospects, countries reliant on tourism, and commodity exports for example.
The big 5 techs stocks are a good proxy for the overall technology space – the quintet (Apple, Amazon, Alphabet, Microsoft, Facebook) reported combined net income of $159bn in 2019 on revenues of $899.2bn. At current valuations the tech group is worth $6.24trn (P/E 39.2x and 6.9x P/Sales). In isolation a conventional approach suggests these are high valuations that predict annual profit growth of over 25%. But for at least a decade now valuation has been a bad pointer to outcomes. The tech question boils down to this, would you rather be invested in a highly profitable growth area, albeit one with high valuations or in other areas where profitability is under threat? This is a rhetorical question, in that the answer can be glimpsed in the question!
The US has a big lead over RoW in I.T./ data and the digital transformation. C-19 has magnified the benefits of this advantage. The index weightings provide further insight into index performance. In only three areas, Health Care, Consumer Discretionary and Real Estate are sector weightings similar.
Sector weightings- MSCI world ex USA
|Sector||Weight (%)||MSCI World ex USA||Sector||Weight (%)||Difference (US-World) (%)|
|3||Consumer Discretionary||11.64||3||Health Care||13.09||1.41|
RoW is overdependent on weak financial companies and lower (sub 1/3rd) exposure to information tech relative to the USA. RoW has less than half the US exposure to communication technologies, a key growth area due to 5G and work from home, gaming, enabling technologies.
Another noticeable factor is the energy sector’s shrinkage in both indices. This reflects weaker profits for oil majors as energy transitions from fossil fuels to renewable energy. This factor will hit many RoW countries who lack the offset of the US technology sector.
source; MSCI USA $400.59 Aug 2020 v $100 in Aug 2005
MSCI World Index contains US exposure whilst MSCI World ex USA Index (USD) does not. Over the past 15 years the US has substantially outperformed (4 fold increase v 2005) the RoW (99.9% return) as identified by the MSCI World ex USA Index.
UK indices have lagged their international peers this century. The blue-chip index ended 1999 at 6,930 – this nominal level has been exceeded since for brief periods. UK blue chips ended 1999 at levels not revisited in real terms in over a generation.
With UK indices, factoring in dividends makes a significant difference. Taking the 20 year period from Millennium Eve to 31 December 2019 an investment worth £1000 over the 20 year period would be worth £2,222 (APR 4% if the dividends were reinvested and £1,088 (APR 0.4%) if dividends were spent not reinvested. The blue-chip index ended 2019 at 7,542 c. 600 points higher. Investors need to adjust for UK inflation over the last 20 years which cumulates to 75% – £100 in 2000 is worth £175 in 2020. A total UK index investment of £1,000 in 1999, inflation adjusted would be £1,750 in December 2019 and be worth £2,222 i.e. +27%.
When comparing UK returns to international returns as above, in USD, the 2005-2020 period for the UK is uninspiring.
When measured in USD from 2005 (15 years) as above, the MSCI UK Index is up only 41.86% less than half the RoW and just over one tenth of US returns.
‘Brexit’ in delivering a permanently low sterling value has hit UK returns in USD. Brexit’s ramifications and the lack of any resolution is a series of events that overseas investors pre-2016 had not bargained for. It has placed a question mark over the UK’s tilt i.e. EU membership/ EU partnership being replaced with direct confrontation and competition with the EU. Put bluntly the UK is badly placed to compete head on with the EU, the UK has a large trade deficit with the EU, has weak manufacturing capabilities, is overexposed to financial services, the EU has far better global reach in terms of its ability to sell products that global consumers buy. The EU is considered a trustworthy and reliable trade counterparty. Post 2016 the UK’s behaviour has damaged its international reputation.
source; MSCI UK $141.86 Aug 2020 v $100 Aug 2005
|Sector||Weight (%)||MSCI World ex USA||Sector||Weight (%)||Difference (UK-World) (%)|
|3||Health Care||13.99||3||Health Care||13.09||0.90|
|11||Real Estate||1.29||11||Real Estate||2.86||-1.57|
Without exhausting the point, UK equity indices have too low IT and too high financials. Brexit/ C-19 has not helped UK financials as both represent significant operational and access to market risks.
The UK has limited exposure to digitisation, online assets, internet infrastructure such as cloud/ social media. In terms of listed companies there is ASOS, Aveva, Ocado, MicroFocus, Qiniteq, Spectris and Sage. Should a UK tech strategy be de-facto focused on this core group? If a ‘golden share’ structure made these companies’ acquisition subject to statutory consent, in that environment they could form a sustainable core tech group. Without that structure UK tech is vulnerable and up for grabs. The current group is small but so was the top tier US tech group, once.
As industries shift operations invest online and divest elsewhere the concern is the impact on the UK’s traditional ‘bricks and mortar’ assets. How do banks, retailers, property companies manage the transition to a world that requires lower actual physical assets?
C-19 might offer a silver lining – it has provided the time and opportunity to change priorities making it easier for companies to make changes quickly to shift the sourcing of revenues online. This short-term factor will impact unemployment.
The UK’s soft regulatory touch encourages overseas buyers for UK companies. In 2019 UK companies accounted for over 25% of total M&A deals in Western Europe worth $290bn in total (UK was the 3rd largest target country globally).
A recurring theme is UK M&A on a net basis is a net sell. “Inward” M&A (foreign companies acquiring UK companies was £11.1bn (Q4 2019) v “Outward” M&A (UK companies acquiring overseas) stood at £3bn – almost a 4 fold difference.
This factor suggests M&A works on reducing the pool of large UK companies. The UK has ‘lost’ more major companies in the last two decades than other countries, notable departures, ARM, Alliance Boots, BAA, BG Group, Cadbury, Costa Coffee, Just Eat, O2, Shire Pharmaceuticals, Sky, Zoopla.
Corporate UK has long favoured prioritising shareholder dividends. Frankly I cannot find any other corporate philosophy that puts so much emphasis in the ideology and practice of maintaining payouts to shareholders indefinitely and often in priority to numerous other internal business needs i.e. growth, investing in the right people and processes, infrastructure, making the right acquisitions, etc
The dividend cancellations during 2020 are prudent, overdue, cash saving measures. They have highlighted the fact the UK market was too focused on the triangular relationship between banks, companies and shareholders. The funding of UK dividends had become reliant on companies borrowing from the bank to do so. Debt levels had been run up substantially at companies like BT Group, Imperial Brands, ITV, Vodafone to name a few, to fund shareholder payouts.
There has been mixed messaging on this issue bordering on dishonesty. Companies claim they can afford payouts, then dividends are stopped abruptly, shareholders are asked for the same money back again, in a rights issue or placing. It amounts to a “shell game” that has come home to roost. The objective should be to pay an honest dividend without having to ask for it back.
UK companies paid £16.1bn in dividends over Q2 2020 down £22bn over Q2 2019. According to Link Group it was the lowest amount since 2010, the major factor being the decision by the Bank of England to block banks from paying dividends (31st March 2020). Under a scenario analysis UK dividend yields could yield between 3.3% to 3.6% over 2020. Is this an honest and affordable yield now? Maybe.
C-19 might offer a silver lining here as well. It provides cover to rebase dividends and the space to repair balance sheets via fresh equity issuance.
In an age of fickle customers using new routes to market, maintaining a cutting edge is vital. This requires the right approach to IT hardware, software and data management – a significant and ongoing investment spend. Up to now, the UK has skimped in this area to fund dividends. Many companies now are asking for that same capital back. This circular activity is self-defeating and what has been lost is the opportunity to upgrade and invest in the business.
C-19 has exposed cultural gaps, and issues that appear odd and mismatched. Apple Inc (now worth more than the UK blue chip index), heavily loss-making companies on IPO apparently worth $70bn. A rising membership of US$1trn market cap companies alongside the persistent decline of old favourites. What can we glean from the tumultuous events of 2020?
a) Yes, there may well be anomalies, bubbles, irrationality. These can persist and have persisted for many years. This has become a normality of itself. “Plus ca change”.
b) Yes, the US market is expensive, there are good reasons for this, it might well be sustainable in an environment where alternatives are more unpalatable such as now.
c) There are rational long-term patterns emerging that are helping some countries benefit from C-19 – this may well be a diminishing factor if/when C-19 subsides.
d) The main impact of C-19 has been to accelerate structural changes already underway at a lower pace previously.
e) It is wrong to conclude that investor behavior is irrational or predictable in the long term. Current valuation gaps may well widen further.