Best (And Worst) Of British

16/10/2015 at 4:49 pm

Economically speaking there has been little drama or excitement in the UK over recent months. While markets agonized over Greece, and then China, and subsequently the Fed, the British economy quietly kept on going. There have been no growth surprises in either direction; no change to the Bank of England’s guidance or rhetoric on interest rates; no unexpected outcomes in the labour market, or price indices, or activity indicators. The PMI survey for September showed a bit of weakening in output. And Mark Carney did have some diverting things to say about topics other than monetary policy (climate change for instance). But all in all, it has been an uneventful time.

Nonetheless the UK markets are of key importance to British investors and do not always reflect goings on in the economy, to say the least. So while the economy might not invite too much scrutiny just at the moment, here is a summary of conditions across the major UK asset classes.

Starting with property, the residential market rally that took off in 2013-14 continued into this year but has abated somewhat. Government data showed a 5% increase in house prices in the twelve months to August, down from a 12% annual rate in the early autumn of last year. Valuations are mixed: the simple average earnings to average house price measure suggests the market is red hot but on this measure that has been true since 2004. Using a measure of mortgage affordability (which takes account of interest rates) the market is priced fairly: the ratio of average mortgage payments to average earnings is almost exactly in line with the average since 1976.

The commercial property market has been having a jollier time of things, with the Investment Property Databank All Property total return index up 15% over the twelve months to September. Again, the valuation picture is mixed. Rental yields have fallen sharply over the last couple of years and are about as low as they were at the peak of the late 1980s boom (though still a little way off the lows seen before the Great Recession). On the other hand, the rate of capital growth has not been as aggressive as in previous rallies and there is some distance before the market surpasses its 2007 peak.

Staying at the riskier end of the spectrum the equity market has been picking up nicely in recent days. The FTSE 100 has risen by 5% so far this month and is now 8% above the low it marked towards the end of August – though remains 10% below the record set back in April. There has been pressure on earnings from currency and commodity effects this year so the improvement in valuation since then has actually been rather muted: the forward p/e ratio has risen from 14x to 16x, which looks toppy against a ten year average of 12x. At the same time, however, the dividend yield has risen from 3.5% at the end of last year to 3.9% today (the ten year average is 3.6%).

Talking of yields, the gilt market has barely shifted from where it began the year. All the key maturities – two year, five year, ten year, thirty year – as well as the ultra longs are within 10bp of where they ended 2014. There is one exception: the ultra long end of the index-linked market has rallied, with the yield on the 0 3/8% 2068 linker down 16bp to an uncompelling -0.8% in real terms. The ten year conventional gilt yield stands at 1.8%.

Corporate bonds have similarly had a dull time of things, at least in the investment grade arena where widening spreads have seen total returns of about 0.5% according to the Bank of America Merrill Lynch family of indices. High yield has done better: spreads are about where they were at the start of 2015 so there has been relatively little capital impact on income return (the total return on the sterling high yield index stands at 4% for the year to date). In valuation terms credit spreads are much higher than they were in the years preceding the 2007 crunch but not very compelling against average levels given the scale of the collapse at that time. Using the Markit iTraxx Europe index as a benchmark the price of investment grade credit is just over 80bp today, up from a pre-crisis low of 20bp but somewhat below a ten year average of 90bp.

There is nothing much to say about cash with base rate stuck at 0.5% for the last six and a half years, though the worst performing assets of all are to be found in the commodity space. The near Brent crude oil future has rallied from the new bottom it reached in August (by some 14% in fact), but is still worth less than half what it was before the crash last year. The economic and market consensus is for very limited improvement over the coming months and with supply still materially stronger than demand there seems little reason to argue with this. There would also appear to be the will in some important quarters for oil to stay cheap: Saudi Arabia alone increased daily production by just over one million barrels during the first seven months of this year.

Precious metals have had a better time of things too lately and both gold and silver are trading very near the levels at which they began the year. Still, gold at $1183 an ounce remains expensive relative to inflation-adjusted 30 and 40 year averages of $793 and $825, even though that price is almost 40% below the $1900 reached at the peak of the bubble.

At this point we have departed from strictly British assets of course but that, at least, is all the key bases covered!

It has not been the easiest of years for UK investors and readers will have noted that this blog sees continued volatility ahead. But there are always opportunities amid uncertainty. Time will tell if we are able to find them out.

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