Our latest investment commentary from Avellemy Chairman, Graham Bentley

Graham Bentley

June marks the 2021 markets' half-time break

After a month where every fund sector produced significant positive returns apart from UK equities, forgive me if this commentary chooses to focus on our home market rather than a 'round the houses' review of global economics. Furthermore, while writing in the midst of the UEFA Euro 2020 tournament I can perhaps be excused a token football reference, but June marks the 2021 markets' half-time break. It also records the 5-year anniversary of the referendum on EU membership; that the intersecting fault lines of COVID and Brexit may cause a significant and positive shift in the outlook for UK companies' shares is worthy of deeper analysis.

Looking back five years

Looking back five years, it is clear the Brexit result came as a shock to investors, not only in the UK but to those elsewhere. Following the result, the pound lost 10% of its value versus a basket of other currencies and by October had fallen another 11%. UK shares which had traded at very similar valuations to markets elsewhere, were some 20% cheaper than the rest of the world by the time the pandemic was declared in 2020. By pretty much any measure, UK shares have underperformed relative to the rest of the world since then.

The opening of the 2021 saw the peak of COVID in the UK, with almost 40,000 people in hospital and over 1300 deaths a day where the virus was deemed a contributing factor. Vaccinations began in earnest, and this last point is significant. Whatever one's political allegiance, it is clear the government's programme of vaccination rollout has been a relative success, significantly ahead of the US and our erstwhile European partners, in terms of the speed at which 50% of the adult population received their first dose.

UK employment statistics edge closer to pre-COVID employment levels

The first half of 2021 has seen the UK employment statistics reflect the benefits of paying companies to keep workers employed, rather than the US approach of 'helicopter money', i.e. handouts directly to those laid off; the UK is now significantly closer to pre-COVID employment levels than the US. The Bank of England has been slowly turning off the QE tap, with asset purchases amounting to less than 40% of GDP, while our erstwhile European partners' central bank balance sheet approaches 70% and shows no sign of easing.

It is estimated that the pandemic restrictions have allowed additional consumer savings of some £140 billion versus the previous four quarters, while retail sales are back at pre-COVID levels, despite supply chain problems and slow deliveries as businesses strive to regain pre-COVID production levels. The stamp duty holiday for the first £500,000 of a property purchase has fuelled a remarkable rise in residential property values, with Nationwide reporting a 10% year-on-year; the average house price in the UK exceeds £240,000 for the first time.

An abundance of positive narrative concerning the UK stock market outlook

There is an abundance of positive narrative concerning the UK stock market outlook.

This is important, because investors' decisions are often driven by stories, but we don't just have tales to tell here; there is data to support it. The market is cheap by historic standards. 

If I divide the price of a share by analysts' expectation of that company's earnings per share (i.e. next year's profits divided by the number of shares in issue), the result is a "Forward P/E" ratio that effectively tells me how many years it might take to get my initial investment back as profit. The higher the ratio, the more expensive the share is, relative to its current earnings. A higher P/E than the market average tells me investors are very optimistic about a company's future, and vice versa. However, the records tell us that over time, analysts' estimates tend to swing between extreme optimism and severe pessimism. Certain shares and indeed whole markets then become too expensive, or too cheap. There is a very strong inverse relationship (80% correlation for the statistically minded) between the forward P/E, and its subsequent annual return over the following ten years; the lower the P/E, the higher the return and vice versa. Forward market P/E ratios higher than 20 typically have relatively low single digit and even negative returns over the next decade. Those in the low teens however have historically tended to have double digit annual returns.

The US market (as represented by the S&P 500) has a forward P/E of over 21. The UK market is very cheap both against other major stock markets and its own historic average, at a forward P/E of around 14. During June, the wider UK market was virtually unmoved; however, UK Smaller companies have rewarded investors with almost 20% return over the first half year, and UK 350 "value" companies over 15%, both higher than the US S&P 500 index. 

A limitation of passive investing is that it can commit ever-higher proportions of money to those areas that have performed well and therefore constitute a greater proportion of an index, e.g. the US and by association technology. An advantage of active management is that it can recognise undervalued assets and allocate capital accordingly. Model portfolio services that utilise regular rebalancing ensure that holdings that occupy increasing proportions of a portfolio take profits, with proceeds reallocated to areas that have done less well. In that way portfolio risk is maintained, while perhaps unexpected growth and recovery opportunities are not overlooked. 

UK equities are a case in point - let's see what the second half of 2021 brings.