Briefing on UK economy and stock market
Since 1979, the UK economy has shown a level of economic growth, inflation and stock market performance that essentially corresponds to the average, Western economy. With the City at the very heart of the UK economy, the financial market booms (1982-1987, 19921999 and 2003-2007), and busts (1988-1992, 2000-2002 and 2008-?) may have led to dramatic headlines, but in terms of the performance of the economy as a whole and the overall stock market, the UK has been resolutely average amongst western economies.
The UK stock market has long been dominated by UK-based multinationals that have outgrown the UK economy - BP, Shell, Glaxo, Vodafone, Unilever and Diageo are the well-known names here. However, London has, in recent years, also become a preferred listing location for many other global companies such as HSBC, BHP Billiton, and Xstrata. The fortunes of all these companies are tied to the global economy rather than the UK economy and yet they represent more than one half of the UK stock market’s value. Exposure to the UK economy is best found at the smaller end of the range of UK listed companies.
Historically, the best way to value the UK stock market has been through its dividend yield. This stems from the commitment of most UK companies to maintaining or improving their dividends to shareholders, and the enormous size and power of UK Equity Income funds. In general the market dividend yield has traded between 3% and 4%. In periods of fear and recession this has risen to 5% and in times of boom and optimism it has fallen to nearly 2%.
The UK has persistently produced both trade and budget deficits in recent decades. In addition, the UK consumer became steadily more indebted from 1982 to 2007, as the financial sector was deregulated throughout the period, which culminated in very high house price to disposable income ratios and very high levels of personal debt. The UK consumer is now showing clear signs of wishing to reduce borrowing levels. This reversal means that, until debt levels have fallen back to more reasonable levels, sustainable economic recoveries in the future can only be led by exports or investment demand.
The budget deficit is also a source of concern since much of it is structural (at the economic peak in 2007, when government finances should be at their healthiest, they were in fact showing a sizeable deficit, due to the very high levels of public spending) - this will require a long period of steadily bearing down on UK government spending. More rapid austerity efforts are likely to be counter-productive as has been seen in Europe.
Most encouraging has been labour market data. The private sector has been creating jobs at a faster rate than the public sector has been shedding them since the end of 2010, and wage rises remain low. The implicit loss of productivity from a weaker economy (near zero growth since Q3 2010) but a stronger employment market is partially explained by the performance of two key sectors, oil production and finance. In oil production, the fact that North Sea oil has passed its peak production rate means that it is getting progressively harder and more expensive to produce the oil. In finance, the regulatory changes being forced onto the banking, insurance and personal finance industries are boosting costs and reducing revenues.
The UK today
The policy mix of steady fiscal austerity and very easy monetary policy is set to continue, if only because both are effectively default policies. Fiscally, a reduction in the structural deficit is necessary and generally agreed upon by all parties; the only disagreements being over the pace and size of the programme. Recent research by the IMF, coinciding with public concern about spending cuts in many countries, has concluded that too rapid or too harsh an austerity programme can do more harm than good. A pace of 1% targeted reduction in the structural budget deficit seems the appropriate course for the UK. Given this steady fiscal tightening, monetary policy needs to remain very easy, in the absence of clear inflationary concerns, to support growth. The problem is that monetary policy is least effective when interest rates are near zero as they are currently.
In the medium term, until the budget deficit has returned to sustainable levels and consumers feel more comfortable with their levels of debt, the UK economy will struggle to grow faster than about 1.0 to 1.5% a year. With inflation expected to remain close to the Bank of England’s target of 2% a year, revenue growth and thus profits growth for UK companies will be hard to find.
In terms of the valuation of the UK stock market, a dividend yield of between 3% and 4% is normal and a price-earnings ratio of 11-14 times would also be typical. Based on the current market expectations for 2013, at FTSE 5800 the market is valued at the bottom end of that normal range on these criteria.
The future for the UK
The medium-term growth outlook for the UK economy and stock market looks uninspiring. This, however, does not mean bad. The economy has to work through a period of both lower public sector demand and muted private consumer demand and these will feed through into lower economic growth rates for the whole economy.
With valuations relatively low, the scope for a substantial decline in share prices seems limited, barring some major disaster. There is scope for some earnings growth from UK companies and also some scope for slightly higher valuations. However even then it is likely to take three or four years of modest earnings growth until the fair value of the market moves above the 1999 peak.
Though the immediate prospects for growth of revenues for UK companies are not dramatic, it is important to note (i) that corporate profitability is reasonably strong, with above-average profit margins and (ii) that, in an era of low inflation, the conversion of those profits into free cash flow is also strong. Companies are generating substantial amounts of cash each year which are currently being used to bolster their balance sheets, but should, in time, be used to invest in their businesses, engage in takeover activity or increase their dividends.