Equities have fallen, classically riding on the back of
the weakening bond market and of recent, exacerbated by US wage growth data
which has accelerated the rise in bond yields. Specifically here I refer to US Treasury
Bonds (UK equivalent gilts) where we see 2 year yields over 2% and the
benchmark 10 year yield around 2.8%. 3% yields look plausible and a pause there
In simple terms, this means interest rates are believed
to be moving quickly higher to combat inflation in America. This represents a
big macro change to the low rates, stimulus heavy environment we have been used
to for 9 years since the financial crisis; an environment within which share
prices have soared.
Bond prices (government and corporate) move in the polar
opposite direction to interest rates (actual and perceived) as a fixed
(interest) return brings much reduced appeal when returns are rising elsewhere (in in bank accounts for
instance by way of savings interest). Typically
equities have themselves to compensate by falling in price to likewise offer
higher yields as asset prices adjust. Furthermore, equities need (ordinarily)
to dividend yield in excess of bonds to compensate investors for the heightened
risk taken by investing in a company’s shares over a company’s bonds: the
“yield gap” refers to this typical difference.
Shares constitute the risk capital of a company and can demonstrate much
higher volatility if ultimately, returns can be higher through share price
appreciation and the potential for increasing dividends over time. Conversely
shares can fall significantly in value in comparison to a corporate bond which
will hold its value better.
The 10% correction we have now experienced is as much
about a forced reaction to the rise in corporate bond yields as it is the fact
that share prices (especially in the US) have simply risen too far unabated.
Nothing goes up in a straight line (fact) and an asset bubble was being created
before the recent sell off. Actually what we have witnessed (I would say) is a
healthy repricing of risk, not a catastrophe but assuming a global recession
isn’t ahead instigated by interest rates rising too soon and too fast. The
market may actually have done the US Fed a favour by correcting itself prior to
the central bank having to take the flack for cratering the market.
All geographies have seen share price falls not just the
US and UK but Japan, Europe, Asia and Emerging Markets too. Some have been more
pronounced primarily as some have risen to higher relative valuations. The US
and Japan would feature here.
Oil has not been immune and itself has weakened over 10% (and
into correction territory) from its recent highs.
These asset price falls while making for slightly uncomfortable
viewing have not been a surprise to most. Indices until recently bore all the
hallmarks of running out of gas with incremental rises witnessed alongside near
zero volatility (fear). In a word, the market had become complacent.
Taking a shorter term view, new buying opportunities have
now emerged (more later). For medium to longer term investors, this is likely a
short term bump in the road that will be ironed out over the next few months I
would suspect. This view is (again) caveated: that the economic landscape is
not about to change for the worst.
We are not panicking if a little rattled, holding good
quality shares if out of favour for now.
Market Specific Comment
The consensus view (I believe the correct one) is that
further opportunity has been created as a result of the market fall.
Accordingly I list below a few large cap stock specific options worthy of
current consideration. These should not be considered investment advice to non-clients,
nor non suitability tested individuals. Investing
against the trend is never easy but buying when others are fearful is a
fulfilling mantra often cited by professional money managers.
Vodafone (201p). Shares back to one year low further to a
15% slide over the past five weeks alone. Big technical (chart support) now seen
with a projected 6% income yield on the stock at this price. International
mobile telephony giant currently eyeing an asset purchase in Europe potentially
from Liberty Global. Company has
recently updated the market and backed guidance for 2018.
Imperial Brands (2605p). Staggering fall from grace with
shares now 35% down on the year high around 4000p. Price to earnings ratio now
under 10 with a cash backed income yield over 7%. Last week company committed
to a 10% dividend growth policy. Foreign exchange headwinds will hurt profits
2-3% this year and can kicked into second half requiring an improvement on the
first half to meet expectations. Labelled a so called bond proxy, its price is
on a major slide (akin to the bond market perhaps) but focusing on the
fundamentals as opposed to the chart(!), this warrants a look.
Lloyds Banking Group (66.5p). UK centric lender, strong
capital ratios and presumed beneficiary of rising interest rates. 7.5% decline
over past 3 weeks places the stock back near technical support level with a
forecast PE ratio of 9.5 and income yield of 6% plus over the next 12 months.
Notwithstanding further potential PPI provisioning requirements (which have
sapped cash), risk reward for the stock (sector even) favours to the upside.
Aviva (490p). Shares have returned to year lows now to a
10 Price to Earnings forward multiple and yielding a growing 5.2% income.
Whilst it has lagged the performance of Asia focused Prudential, new management
are positioning company well for potential large scale dividend pay-outs on
back of strong earnings growth (flagged end of November 2017). Also a likely
beneficiary of the rising rates outlook.
Edinburgh Investment Trust (645p). £1.27 billion market
cap, out of favour collective investment now yielding over 4% with quarterly
distributions. Performance over past year plagued by unfortunate exposure to
Provident Financial and Capita amongst others. Invesco’s Mark Barnett and former protégé of
Neil Woodford is the lead fund manager. Down 17% on the year, this offers a
contrarian opportunity in the belief that performance will improve over the
next twelve months. Largest holdings include BAT, BP, AstraZeneca and Legal
This report was written by Philip Scott, Director at SI
Capital on 13/2/18 when the FTSE 100 was trading at 7168.