When things are so bad, they're actually good

When people start to talk in terms of a ‘national emergency’, as the CBI and TUC did in a joint letter to the Prime Minister, contrarian investors’ antennae start twitching. Rightly so. The three-day week, the miners’ strike, the ERM crisis, Northern Rock. These were all good times to invest in the UK stock market. So, I’m inclined to think that our current political humiliation may be just the latest example of things being so bad they are actually good.

I hesitate to comment on the Brexit drama if there will be a delay of more than a few hours between my writing the words and anyone reading them. Never in the history of human punditry has so much commentary been overtaken by events so quickly. But if anything is clearer after Theresa May’s visit to Brussels last week, it is that a no-deal exit is looking less likely. How things pan out in the end is unclear, but the stock market’s sang froid since Christmas is starting to look prescient.

Whatever your personal view of how the cards should fall over the next few weeks, there is little question that the softer the Brexit the warmer the financial market reaction will be. This is most clear in the currency market. But the stock market also has an unsurprising preference for the less economically damaging options.

The UK market’s concerns about Brexit have been disguised in the three years since the referendum. Partly that’s due to the international nature of the FTSE 100, which earns most of its profits overseas and pays its dividends in large part out of dollar earnings. In sterling terms, it looks like we’ve gone sideways. To see the full extent of the damage to sentiment, however, you need to look at the performance of London-listed shares from the perspective of an investor in New York, Singapore or Tokyo. In dollar terms, the FTSE 100 has underperformed the rest of the world by about 20pc over the past three years.

Overseas investors have rarely been as out of love with the UK market as they are today. The latest Merrill Lynch fund manager survey, published last week, confirmed that the UK is the most unpopular destination for investors at the moment. This is not unreasonable when you consider that UK shares only represent about 6pc of the total value of global stock markets. For investors beyond our shores, the effort of trying to understand Brexit, let alone the civil war in Westminster, has just not been worth it.

It would be easy to blame our pariah status completely on Brexit but that would be wrong. It is actually a symptom of a wider aversion to uncertainty and volatility that has been in evidence ever since the financial crisis. The 2008 shock was a deeply traumatic event for investors and their attempts to avoid a repetition of the pain it caused are still shaping markets a decade later.

Over the past 10 years, investors have been prepared to pay a significant premium for predictability. They have shunned uncertainty wherever they find it. Brexit Britain is the most high-profile example, but it is not the only one. The volatility and cheap valuations of shares in China, for example, are a consequence of investors’ unwillingness to believe the economic data. An unclear outlook also explains why Japan and Europe have been so out of favour. Faced with uncertainty, investors have preferred to pay a higher price for the apparent transparency of the US and the perceived steady and reliable growth of, for example, the FAANGs.

This fear of uncertainty and volatility is also evident in the growing preference for illiquid asset classes like private equity, infrastructure and real estate. It is not just that steady income streams have made these investments more predictable for investors, the absence of a minute-by-minute price-setting market for these assets has protected investors from the gyrations that make stock market investing so stressful. We cannot bear too much reality.

Aversion to uncertainty also goes some way to explaining why value has been such a poor indicator of future returns in recent years. In less traumatised markets you might expect investors to gravitate towards apparently cheap investments on the grounds that over time everything eventually reverts to the mean. In fact, the reverse has been the case. Growth and quality have consistently outperformed value, as investors have become curiously price-insensitive.

The result of all this has been that the markets with the least visibility have become the least expensive. The UK is now cheaper, whatever your preferred measure might be, than Europe, Japan, emerging markets or the US. Whether you look at the multiple of expected earnings you are required to pay for UK shares, or the income with which they reward your patience, our market is in the bargain basement. And the closer you get to home the bigger the discount. Domestic, smaller companies have consistently underperformed the larger, international-facing FTSE 100 stocks.

This may persist, but investors should consider the possibility that the expensive growth and quality stocks turns out to be less predictable than the market expects. Regulation and more intrusive tax authorities might reduce the already diminished appeal of the big US tech stocks. Equally, the fog of uncertainty clouding the outlook in Britain could clear surprisingly quickly.

A willingness to overpay for certainty has served investors well over the past ten years. It is not a given that it will continue to do so. As the hand-wringing and self-doubt intensifies, home bias has never looked more sensible.

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