Archive for February, 2015

Breaking Records

There was some cheerful news for the UK equity market this week as the FTSE 100 index closed at a record high of 6949, finally beating the previous high – 6930 – it had reached way back on 30 December 1999. This milestone has generated a lot of comment on topics such as its relevance as an economic indicator and whether it comes as a sign that investors should sell. So what, if anything, does the record-breaking date of Tuesday 24 February 2015 tell us about the value of the market?

It has taken more than fifteen years for the 1999 record to be beaten. That is a good long time in financial markets, and perhaps especially so for markets in growth assets which have historically offered long run real returns of 5% per year. Had December 1999 been a textbook average starting point for investing in the UK stock market, then, and dividends from the FTSE 100 precisely matched the rate of inflation over the period we might have expected to see a price return of 1.05^15, or 108%. That would put the index on a level of 14407 rather than 6949 today.

When assessing markets, of course, we should not look at price alone. December 1999 was very far indeed from an average starting point. The price / earnings ratio for the FTSE 100 peaked that very month at 30.5x, de-rated sharply over the next couple of years and continued to descend more gradually, but very steadily, to lows (for the time) of around 12.2x in the summers of 2006 and 2007. This of course reflected the absolute reversal in sentiment from euphoria to depression associated with the collapse in the TMT / internet stock market phenomenon of the 1990s. During the Great Recession and its aftermath the p/e had a few bouts below 10x and has now bounced back to 16.6x, slightly above its twenty-year average level and somewhat lower than the 19.1x midpoint of its low-high range over that period.

Of course what this means is that the valuation picture is much more supportive of this new record price level than it was back when we last saw it at the end of the boom-boom 90s. This is even more the case when we flip the p/e ratio on its head (1/16.6 giving the conveniently round percentage of 6.0%) and compare this resulting earnings yield to a ten-year gilt yield of 1.8% and cash savings rates mostly below that. Back in December 1999 the earnings yield on the FTSE 100 was 3.3% as against 5.5% on the ten-year gilt and, by coincidence, a Bank of England base rate of 5.5% as well.

So breaking the 1999 record is not an obvious sell signal, and tells us at least as much about market sentiment and overvaluation back then as it does about those things today. On the other hand, given how close the current valuation metric is to its long(ish) run average, we should perhaps be expecting a total return of 5% plus inflation should 2015 turn out to be an equilibrium year for the UK market – but wouldn’t you just know it, we’ve had 5.8% of that already for the year to date. Still, a few months’ stagnation now is a small price to pay should that 5% real rate of return compound us forward for the next fourteen years from 2016 onwards. Again making the frivolous but convenient assumption that dividends match inflation, that would put the FTSE 100 on a price of 13758 come the end of 2029.

Perhaps worrying about price points at specific dates is not as useful a decision-making exercise as some others, then, especially when those dates are so very far apart. With the market at its current level it is obvious that it could move in either direction from today until the end of the year. Where it stood in 1999 is really not relevant. Before abandoning the notion of record stock market levels entirely, however, let’s briefly compare the positions of the other major developed-world blue-chip benchmarks.

In the red-in-tooth-and-claw corner stands the S&P 500, which has been consistently making new record highs since early 2013. (Its latest was 2115 on Tuesday, way ahead of the previous cycle peak of 1565 seen in 2007 and the dotcom era high of 1527.) In the very much bluer corner is the Nikkei 225, which rocketed up through Japan’s 1980s economic miracle to a high of 38915 on 29 December 1989. Today it closed at 18797, and will need to grow another 107% before it can eclipse that level, which could clearly take some time. Also looking rather glum is the Euro Stoxx 50, marked at 3572 at the time of writing down from prior peaks of 4557 in mid-2007 and 5464 in March 2000. (As an aside at this point, some of the British commentary on the new record has pointed to Germany’s DAX as an example of an index which has long eclipsed its 2000 peak. Unfortunately, however, the DAX is a total return index, meaning that dividend payments are rolled up in its value, giving it an unfair advantage against plain old cap-weighted price indices like the Footsie. The MSCI Germany index, by contrast, has beaten its 2007 peak but remains below its all-time high of March 2000.)

Again, the various record levels reached by these markets can tell us a lot about the start as well as the end points. The pitch of excitement – and in other parts of the developed world, awe – over 1980s Japan is well captured by that long-ago market pinnacle that will not likely be scaled again for many years. But it is instructive also to look at those peaks and troughs which are common to all these (huge and important) equity markets: highs across the board at the turn of the century, then again in 2007, and on the other hand the sharp falls in Q3 2011 … At times like these markets move in concert because they are thinking in concert – sometimes justifiably, sometimes not. The divergence between their performance over the last couple of years tells us that this is not happening yet. Again, there is good reason why this should be so when we consider differences in earnings, valuation, economic and sentimental factors between the different indices, but it should probably give us comfort too that the new closing record for the FTSE 100 is not part of some global rapture as it was fifteen years ago.

Apart from anything else, it never does any harm when an event like this comes along to provoke thinking and discussion. So well done to the UK stock market for beating its record, and let us enjoy sifting through the analysis before attention moves on.

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27/02/2015 at 4:00 pm

The Joy Of Negotiating

While they may not yet be making headlines across the broader media as in days gone by, the ongoing negotiations between Greece and her creditors are the subject of the most widely-read article on Bloomberg today. Entitled German-Led Bloc Willing To Let Greece Leave Euro, the piece has the following money quote from Edward Scicluna, finance minister of Malta:

Germany, the Netherlands and others will be hard and they will insist that Greece repays back the solidarity shown by the member states by respecting the conditions … They’ve now reached a point where they will tell Greece ‘if you really want to leave, leave.’

It is now nearly five years since the downgrade of Greek debt caused worldwide panic over the condition of Europe’s sovereign balance sheets, and for much of that time there have been some who have advocated euro withdrawal and default as the solution to the country’s problems. Somewhere near the zenith of this view’s popularity readers may remember that it was Titanically flawed:

First of all, the currency … There would be rapid depreciation – indeed, the possibility that [it] could cease to be transferable internationally. (The Icelandic krone threatened this at the nadir of the recent crisis with the result that the supply of imported food was jeopardized.) Even if the drachma were tradeable, immediate, rapid inflation would occur. At the same time, bank deposits and other assets would have to be re-denominated, decimating the wealth of the nation overnight. These twin effects would demolish household and business consumption and consign the country to a further period of sharp economic contraction.

All well and good, say the defaultists. But at least Greece would be free of her debt!

Yes, and no. Greece is still running a budget deficit and in the catastrophe scenario this would get worse. So unless the Greeks wanted total state shutdown, they would still have to borrow money. Who would be the lenders? The EU; the IMF: exactly the same people who are lending to them at the moment. The conditions imposed by those lenders – who would still have effective control of the country’s economy until their loans were repaid – would be at least as punitive as the conditions they’re imposing now. In other words, there would be at least as much austerity to contend with, and possibly more.

One key feature of the economic landscape has changed since then, however: Greece has been running a primary budget surplus since the middle of 2013. This means that, ignoring debt interest, the government is raising more in tax than it spends. The last available data from the Bank of Greece (for November) has this primary surplus running at 2% of GDP. There are suspicions that the position has deteriorated since, but the key point is that – in theory – the Greek government could walk away from its debt and let its creditors go hang as it would no longer need to borrow money.

Bearing in mind the point about the currency, banking system and the rest, this surplus would likely not last very long in the event of a “Grexit”, so it isn’t that strong a negotiating point. It does, however, make such a decision appear less obviously stupid. This might well reduce the extent to which political will is bent to economic fear. The Greek situation today is therefore arguably more volatile than it was in 2011.

This is certainly not how it seems. The market reaction to Syriza’s election and Greece’s return to the repetitive circus of down-to-the-wire debt talks every few months has been pretty muted. The country’s ten year debt is priced at over 60 cents on the dollar, below the 80 cent level reached before last autumn but nowhere near reflective of the 74% loss incurred by bondholders in the 2012 restructuring. The Athens Stock Exchange index has fallen 24% over the past six months, but that is pretty tame compared to the 69% fall it suffered over calendar 2010 and ’11 – and it is actually some 3% up on the year to date.

The overall market view, then, seems to be either that the current talks are nothing to worry about, or that Grexit doesn’t matter very much. And besides, the Euro Stoxx 50 is up 11% since the end of 2014, last week’s GDP data for the eurozone was a little ahead of expectations, today’s stronger-than-forecast PMI numbers suggested the outlook here remains bright, and while it has bounced a bit recently the oil price remains about 45% lower than where it spent the first half of 2014. (If you add up the individual members you find that the eurozone, not the US or China, is the world’s biggest oil importer by some distance.)

It appears highly unlikely that another major debt restructuring is on the cards for Greece (as opposed to changes to its existing terms). On this basis the relatively sanguine market view looks right. Prime Minister Tsipras could of course decide to give the world a shock, but it remains clear on balance that this wouldn’t do his country much good.

20/02/2015 at 4:47 pm

Election Jitters

Political risk is a familiar concept to investors in certain contexts. Unrest in the Middle East which has an impact on oil, arbitrary rule in Latin America, and more recently excitement in Europe and strife in Ukraine are well-worn talking points which have had material impact on price behaviour from time to time.

Less familiar, though now certainly being talked about more and more, is the political risk associated with the forthcoming general election in the UK. The association of election results with movements in the London stock market seemed to have gone out with flared trousers and the FT 30. But this week, high-profile business leaders have added public weight to the private concerns of an increasing number of market participants that a Labour, or Labour-led government under Prime Minister Miliband would see a return to the kind of soak-the-rich, wage-and-price control maladies which made Britain the sick man of Europe forty long years ago.

We can return to those fears shortly.

Another reason for concern in the minds of some is the level of uncertainty associated with May’s result. The standard methodology for forecasting election outcomes is the “uniform swing projection”, under which the change in vote share since the last election as indicated by opinion polls is applied to each individual constituency. At present, this would give a hung parliament with Labour short of an outright majority by one seat.

As anyone who follows the news will be aware, however, uniform swing projection is shaping up to be a particularly poor guide to the new parliamentary makeup due to hit us in 2015. Taking the most obvious example, the national vote share of the SNP is minimal at around 5%, but within Scotland – which will return 59 out of 650 MPs – they are about bang on the 45% they polled in the secession referendum. With the unionist vote split three ways and more this puts them in their strongest ever position and they are expected to take most of Scotland’s seats. On the other hand, while the strength shown by UKIP over the last couple of years has received a lot of coverage, they do not possess the regional strength necessary to translate a national share of 15% into seats won under first past the post beyond a handful.

Betting markets are a great place to look for how this might translate into outcomes. At the time of writing, Paddy Power odds for Conservative and Labour seats put both parties on about 280, well short of the 326 required for even the most slender and unsustainable of majorities. Money is on the SNP to hold the next largest number of seats, though at only 40 this would still leave them short of being able to form the very weakest of two-party coalitions. Next come the rather emaciated Liberal Democrats at 26 (down from 57 won in 2010), with the other parties all in single figures. Try to translate this into outcomes for government of the country and markets are all over the place: shortest odds are for a Labour minority administration or a continued Con-Lib coalition, though even those manage only 4/1. There are then ten less likely scenarios before one gets to the “Grand Coalition” outcome – a Tory / Labour love-in – offered at a princely 50/1.

The current market, then, is for chaos, and if history is any guide this will mean bickering stagnation for a few months and a fresh election thereafter. Now stagnation is the opposite of uncertainty. The postponement of real change to the country, therefore, would deliver no fundamental grounds for a shift in financial markets relative to where they are today.

Back to the “nightmare scenario” of a Labour victory, in whatever sense. They recently committed by way of a Commons vote to keeping deficit reduction plans in place, simultaneously stating that this was absolutely in line with their own budgetary goals, while distancing themselves from specific Tory policies. The Conservatives, meanwhile, claimed that although Labour had walked through the lobbies promising to reduce the deficit on exactly the same trajectory as themselves, they couldn’t be trusted; and even if they could, would fail to deliver through politically-driven changes to basic concepts of arithmetic which were understandably difficult to clarify.

In other words, on the key issue of the sovereign balance sheet, both parties are in lock step: we would take exactly the same course, but the other guys would do it with a sillier walk. This is the edifying situation in which the mother of modern democracy now finds itself.

Let’s look at some of Labour’s “frightening” policies. They have made noises to the surviving disciples of the late Eric Hobsbawm about re-nationalising things but EU competition law extends to so many areas of the economy nowadays – including the railways – that it is not clear how this might be constitutional and such efforts would certainly meet with legal challenge as a result. 50% top tax is no innovation, and the Tories’ own home purchase duty changes from their most recent budget are in absolute philosophical step with Mr Miliband’s “mansion tax” in this area, and over time would have a similar effect on those perennially plunderable plutocrats at the top of the mythical money tree.

There is much more that could be said along these lines, but to refocus attention to market behaviour let us end with two observations.

Firstly, some of the mouthier rich always protest publicly at the prospect of Labour administrations. Lord Lloyd Webber, for example, famously suggested in 1992 that he would emigrate should Labour win the election of that year. Perhaps it was because of his contribution to the ensuing Conservative victory that he thankfully chose, in the aftermath of the 1997 Labour landslide, not to do so. (In the instance of this year’s contest, one of the higher-profile mouthpieces has taken the sensible precaution of neither being born nor dwelling here to begin with.) In any event such protestations bear even less relation to the economic outcome for the country than they do to election results.

Secondly, there really was the prospect of serious political change in the United Kingdom recently when the referendum on Scottish secession threatened to reduce it to the more traditional “Union of Crowns”. There was even one especially interesting weekend over which the SNP looked to be winning.

Markets did nothing as a result.

It looks certain that May of this year will bring forth a black swan to exercise temporary notional control over the government of Britain. As readers will know, it is otiose to try to plan for black swan events. It is equally otiose to expect a stagnant quagmire to yield volcanic change, or for parties wedded to near-identical policy platforms on key matters to make too much of a difference to (say) the earnings of Vodafone, the path of the RPI index or the yield on the ten-year gilt.

This year’s general election will be exciting for those whose emotional perspectives allow for that reaction. But anybody who thinks it will be anywhere near as exciting, or dangerous, for financial markets should consider calming down.

06/02/2015 at 5:24 pm


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