How will 2017 be defined? My guess is that we will look back and see it as the year of consequences. The one in which we all started having to deal with the long-term fallout from the great financial crisis and the great monetary experiment it kicked off – the age of quantitative easing and ultra-low interest rates.
The experiment has played a large part in causing asset prices worldwide to soar (all assets tend to be priced relative to the interest rates on offer on government bonds), widening the wealth gap between rich and poor, old and young.
It has slashed the government’s interest bill, allowing it to feign prudence. It has kept companies that should be bust technically solvent. Among other miseries, it has destroyed the UK’s once brilliant defined benefit pension schemes, turning minor funding shortfalls into monster deficits (it is complicated but, in a nutshell, deficits go up as the gilt yield goes down).
This in turn has forced listed and private companies in the UK to shovel cash into their pension funds at the expense of investing in either a productive future or, by extension, wage increases.
It has also, however, done something rather more corrosive: it has challenged our democracy. As Charles Bean, former deputy head of the Bank of England, said in the Wincott Annual Memorial Lecture, thanks to the “distributional effects” of extreme monetary policy, the distinction between monetary policy and fiscal policy is increasingly blurred. An unelected body (BoE) has effectively presided over a whopping transfer of wealth from ordinary savers to asset-rich people. Not good. Did all these things contribute towards the vote for Brexit and the rise of Jeremy Corbyn’s Labour party? Of course they did. How’s that for consequences?
That’s the bad news. Now on to the good. In the main, investors don’t much fancy the uncertainty of Brexit. And they really don’t fancy the economic madness that is likely to come with shadow chancellor John McDonnell and his promise of a “radical” first 100 days should poor Theresa May’s government give way to a general election and a Corbyn victory.
So they are selling out of the UK economy. According to Hargreaves Lansdown some £2bn has been withdrawn from funds investing in the UK this year already. It isn’t just individual investors either: fund manager surveys show that UK equities are unpopular in institutional portfolios.
This is beginning to make the UK stockmarket look as though it is something rare and special – reasonably priced. Luca Paolini of Pictet Asset Management says the UK is cheapest of all the developed and emerging markets he watches: it is trading on its biggest relative discount since the 1990s.
This amounts to a 30% discount on a price-to-book basis and a 20% discount on price to sales, despite the fact that on paper (and putting pension troubles to one side) the UK corporate sector is in adequate fettle.
That doesn’t mean the whole market looks like a bargain. According to analysts at Exane BNP Paribas, a record number of FTSE 350 stocks trade on price-to-earnings multiples of over 20 times, but there are also more than the usual number of stocks trading on ratios below ten times. The UK is “bifurcated”.
So which type of stock is expensive and which is cheap? In normal times the answer would be about some sectors doing better than others. Not so at present: the valuation gap between sectors is lower than usual.
Instead, investors appear to be allocating cash in the UK market based not on “what a company does, but where it does it”. They will pay about double the price for revenues earned abroad than for revenues earned at home (for Savills over Rightmove, for example). The analysts at Standard Life see this too, and UK funds there are shifting towards domestically orientated stocks – look at the SLI UK Recovery Fund.
Paying a little more may be reasonable. After all, there is no doubt that there are Brexit and Corbyn risks to domestic earnings in the UK – more, I suspect, of the latter than the former. But paying this much more? Perhaps not.
This is a view shared by fund manager Neil Woodford, who has spent the past few months repositioning his portfolio towards what he sees as cheap domestic cyclical companies. More than 50% of the revenues of the companies in his equity income fund now come from the UK, up from more like 40% two years ago.
While share prices languish, his position is “uncomfortable”, he says. This is the same word that Exane uses to describe its conclusion that investors should think about selling UK firms that export for those that do not.
So what should ordinary investors do? The most important part of the answer to that is not to worry about feeling uncomfortable.
Poor Woodford is judged by his investors on a six to 12 month view, whether he thinks that’s OK or not (it’s not). But the rest of us, assuming that the call centre staff at our investment platforms don’t spend their coffee breaks sniggering at our portfolio choices, don’t have to worry about this kind of thing. We can be genuine long-term investors.
Next year isn’t likely to be a stable one. Too much is overpriced, the interest rate cycle appears finally to be turning – something that will have no end of new consequences – and there is political risk at every turn.
So it probably isn’t a bad time to be following Woodford towards the more value-orientated parts of the market, in assets that offer you a margin of safety when there isn’t much of it about.
I’m not sure I would do this via Woodford’s flagship fund, however. A part of his portfolio is unlisted, and that’s a slightly different proposition from the one we are discussing here.
Instead you might look at the Diverse Income Trust (LSE: DIVI) or the Miton UK MicroCap Trust (LSE: MINI). Both are run by the experienced Gervais Williams and are good options for exposure to smaller UK companies, as is the value-orientated Aberforth Smaller Companies Trust (LSE: ASL) (disclosure: it is held by members of my family).
Otherwise try the Temple Bar Investment Trust (LSE: TMPL) (which I hold). It has an impressively low annual ongoing charge of 0.51% and looks to invest in “undervalued and out of favour companies with strong balance sheets”.
If this is all too much for you, and 2017 has terrified you to the point that you feel you can take no risk, I have a suggestion. Do not, as many others are, rush to the perceived safety of bond funds. Rising rates are bad for bond funds. Instead, choose a multi-asset fund with a manager obsessed with not losing money. Try the Troy Trojan Fund. Scaredy-cat that I am, I already hold it myself.
Finally, an offer. If you’d like to discuss any of these things or anything else – except sport – you can bid to have lunch with me in the new year. The cash goes to Alzheimer’s Research UK and lunch (and wine) at George is on the Financial Times. Go to www.ebay.eu/Bid4Merryn.