Views From the Floor

In this week’s edition – This blessed plot? Brexit’s effect on UK valuations; and party like it’s 1996.

This Blessed Plot?

Value is the theme for this week’s ‘Views from the Floor’. Given the rapidly shifting sands, we will avoid discussing British politics and instead turn our eyes to the effects of Brexit on British markets.

The four charts below illustrate that UK equities are trading at historically cheap valuations since Brexit.

Negative sentiment toward the UK is very high, according to the most recent Bank of America Merrill Lynch’s Global Fund Manager Survey. The z-score for UK long and shorts relative to historical data is at -1, the lowest of all asset classes worldwide.

Similar negativity is present in the currency markets. Sterling has been range-bound below 1.20 versus the euro since 24 June 2016, the day of the referendum. At about 11:45 a.m. on November 15, the pound was trading at 1.13 against the euro. This decline has contributed to UK assets being cheaper on a relative basis.

Figure 1. The Brexit Effect

The Brexit Effect

As of 15 November 2018

Turning to stocks, the FTSE All Share dividend yield is 259 basis points above the 10-year gilt yield. As Figure 2 shows, Britain was fighting the Second World War the last time the gap was this high.

Figure 2. FTSE All Share, Basis Point Spread of Dividend Yield – Bond Yield (10 year UK Gilts)

FTSE All Share, Basis Point Spread of Dividend Yield – Bond Yield (10 year UK Gilts)

Source: Morgan Stanley Research, MSCI, FTSE; As of 15 November 2018

The average percentage valuation premium of UK stocks versus the MSCI World is close to 30-year lows, taken across price-to-earnings (‘PE’), price-to-book-value (‘PBV’) and dividend-yield ratios. Compared to the rest of Europe, UK prices are as low as they have been since the collapse of the TMT bubble.

Figure 3. UK Versus MSCI World Average Valuation Premium

UK Versus MSCI World Average Valuation Premium

Source: Morgan Stanley Research, MSCI, IBES; As of 15 November 2018

Figure 4. UK Versus European Shares (ex UK), Average Valuation Premium

UK Versus European Shares (ex UK), Average Valuation Premium

Source: Morgan Stanley Research, MSCI, IBES; As of 15 November 2018

There is no doubt that UK equities are trading at historically cheap valuations since Brexit. On balance, we are using this as an opportunity to selectively add risk.

The Value in Emerging Markets

Valuation spreads – the difference between the valuation of the lowest and highest priced stocks – are the widest in emerging markets (‘EM’).

As of 1 November 2018, EM valuation spreads were one standard deviation above average, according to our calculations. This compared with US and pan-European stocks that are 0.4 and 0.3 standard deviations, respectively, above the mean. In terms of EM countries, valuation spreads in China and Korea are about 1 standard deviation higher than the average.

In EM, only four other episodes show similar levels of dispersion to today: November 1997, October 2001, October 2008 and November 2015. In the subsequent 12 months after valuation spreads widened to one standard deviation higher than the mean, the best quintile of stocks (on a valuation basis) outperformed by about 54%.

Party Like It’s 1996

Last week, we spoke about why we’re currently not at the end of the cycle. This week, we reinforce that view with the use of historical data.

Figure 5 is a visual representation of a quantitative, which measures similarities between the current market environment and historical regimes. Using data from 1971 until 30 September 2018, the quantitative model, which economic statistics, market returns, valuation level, volatility and trends in the bond and money markets. We are then able to compare which historical periods have most resemblance to any given year. Eagle-eyed readers will note that each year does not perfectly resemble itself – under the model’s parameters, for a 100% match, every single day of each year would have to exhibit exactly the same characteristics.

Figure 5: Similarity Modeling, 1971-2018)

Similarity Modeling, 1971-2018)

Source: Numeric Investors, Bloomberg; As of 30 September 2018

The model shows us the best matches for 2018 were 1996 and 2005, with a 91.2% and 85.9% match, respectively. Investors expecting a recession after these years would have had to wait until March 2001 and December 2007. By similarity modeling at least, the party might still have some way to run before the lights go out.

Fear and Loathing in the Oil Markets

There have been two big drops in oil prices this year: in February and October.

Interestingly, both of these drops coincided with declines in the S&P 500 Index and were also preceded by rising bond yields. To us, this implies that the expectations for future oil demand are possibly being driven by fears about the economy and potential over-tightening by the Federal Reserve, rather than by idiosyncratic oil market factors such as shale supply and OPEC.

Figure 6. Brent Crude Versus S&P 500 Performance

Brent Crude Versus S&P 500 Performance

As of 13 November 2018

With contribution from: Ben Funnell (Man Solutions, Portfolio Manager), Teun Draaisma (Man Solutions, Portfolio Manager), Henry Neville (Man Solutions, Analyst), Henry Dixon (Man GLG, Portfolio Manager), Dan Taylor (Man Numeric, Co-CIO), Rob Furdak (Man Numeric, Co-CIO) and Sebastian Meznaric (Man AHL, Quant).