Foreword
By Annabel Brodie-Smith
This month, following the triggering of Article 50, we are looking at the impact of Brexit on both the UK and the EU. It will still be a while before we understand the exact implications of our decision to leave the EU, but despite any uncertainty about the future, markets are holding up.
We have asked Charles Luke, Manager of Murray Income which has an impressive 43-year record of dividend increases, for his thoughts on the impact of Brexit on the UK. Although he expects slower economic growth as inflation begins to bite on real incomes, he remains positive on prospects for his portfolio stating: “although the UK is facing significant uncertainty around the outcome of its negotiations with the EU, the outlook for many UK-listed companies with diversified international exposure is brighter.”
Sam Morse, Manager of Fidelity European Values has provided the outlook for Europe. He comes up with a number of reasons to be cheerful including the improving outlook for company earnings. However, there are reasons to be cautious including: “a busy political calendar in 2017 with French, German and, possibly, Italian elections to look forward to” and a possible knock to confidence due to Trump failing to deliver his economic plans in the US.
You may well be interested to see the collation of managers views on the triggering of Article 50 including the refreshingly honest, Harry Nimmo, Manager of Standard Life UK Smaller Companies Investment Trust who said: “Essentially I’m indifferent to the triggering of Article 50…. History has demonstrated that our kind of lower risk growth-orientated companies can generally flourish regardless of the direction of macro-economic change.”
For all those income seekers, please do take a look at the latest list of next generation investment company dividend heroes. These are the 18 companies that have increased their dividends for 10 years or more but less than 20 years.
Have a Happy Easter and let’s hope the spring weather stays!
Annabel Brodie-Smith, Communications Director, AIC
Dividend heroes:
The next generation
In last month's newsletter, the Association of Investment Companies (AIC) published its list of dividend heroes, the investment companies that have consecutively increased their dividends for 20 years or more. But which investment companies are following in their footsteps?
With inflation rising to 2.3%, it was timely that the AIC published an updated list of the next generation of dividend heroes, namely the investment companies which have increased their dividends every year for 10 years or more but less than 20 years.
There are two new additions to this year’s list, namely Henderson European Focus Trust from the Europe sector and Schroder Oriental Income from the Asia Pacific – Excluding Japan sector, which have both consecutively increased their dividends for 10 years.
Annabel Brodie-Smith, Communications Director at the AIC said: “It’s encouraging in this time of rising inflation that 12% of the investment company sector have increased their dividend every year for ten years or longer. There are a healthy number of next generation dividend heroes waiting in the wings, which have increased their dividends each year for between ten and twenty years. Investment companies’ ability to smooth dividends allows them to hold back some income for tough times ahead and is a key advantage of the structure.”
Next generation dividend heroes
Source: AIC using Morningstar
"The only certainty is there is much to be uncertain about"
By Charles Luke, Murray Income
Charles Luke, Manager, Murray Income Trust
With Article 50 now triggered, negotiations, which will undoubtedly be difficult and complex, around the future relationship that the United Kingdom will have with the European Union can begin in earnest. As investment markets question the extent to which economic logic or populist political ideals will win out, it seems the only certainty is that there is much to be uncertain about.
"The companies we seek to invest in are not immune to the environment in which they operate, but they are more likely to be able to prosper in spite of it, because demand for their products or services is not driven solely by the economic cycle"
– Charles Luke, Murray Income
So far, the domestic economy has performed more strongly than many commentators envisaged post the EU referendum. From here, our view is however that the bigger picture is likely one of slowing growth as higher inflation negatively impacts real incomes. In general, companies are in robust financial shape, but many will be waiting for signs of progress around Brexit negotiations before committing to investment. Net exports should continue to be helped by the weakness of sterling, although fiscal tightening is likely to gently moderate growth. As such, our economists see GDP growth slowing from just under 2% this year, to marginally over 1% next year. Whilst this is certainly not a calamitous fall into an economic abyss, it is clearly a more difficult environment for those companies with significant exposure to domestic demand drivers.
Our belief is that a focus on high quality businesses combined with discipline on valuation and a patient, buy and hold approach will over the long-term stand investors in good stead. The companies we seek to invest in are not immune to the environment in which they operate, but they are more likely to be able to prosper in spite of it, because demand for their products or services is not driven solely by the economic cycle. This focus on good quality companies typically with robust balance sheets and sustainable cash flows leads us to favour companies with well-diversified international revenue streams, an advantage which should shield them from Brexit-induced political uncertainty. We also think of ourselves as owners of these companies, looking carefully at remuneration structures and engaging with management on capital allocation, to ensure that the company is being run in the long-term interests of all shareholders.
Although the equity market has performed strongly, one area in which we are currently finding value is the pharmaceutical sector, including our holdings in GlaxoSmithKline and AstraZeneca. We believe industry concerns over pricing pressure and generics are outweighed by factors including strong long-term demographic drivers, emerging markets growth, increased R&D efficiency and new breakthrough therapies. More specifically, GlaxoSmithKline is turning around its respiratory franchise while enjoying strong growth from its consumer healthcare, vaccines and HIV businesses. AstraZeneca’s immuno-oncology division will be reporting late-stage trial results over the next year or so on a number of very exciting opportunities.
Another company that we believe has excellent long-term prospects is Compass, the foodservice business: structural trends towards outsourcing, further margin improvement and a strong competitive position combined with attractive cash flow generation under the stewardship of an excellent management team are some of the factors that explain why we hold the company in high regard.
"Although the UK is facing significant uncertainty around the outcome of its negotiations with the EU, the outlook for many UK-listed companies with diversified international exposure is brighter"
– Charles Luke, Murray Income
One corollary of sterling weakness is likely to be greater merger and acquisition activity. The appetite of global corporations for high-quality businesses is likely to continue and unlike other countries, for better or worse, the UK currently has limited takeover protections.
Therefore, although the UK is facing significant uncertainty around the outcome of its negotiations with the EU, the outlook for many UK-listed companies with diversified international exposure is brighter. We believe that the principal support for investors in an inherently uncertain world is an appreciation of long-term fundamentals and a disciplined and active approach to investing.
Outlook for Europe
By Sam Morse, Fidelity European Values
Sam Morse, Manager, Fidelity European Values
2016 will be remembered as a year of political “shocks” with three outcomes which, at the beginning of the year, might have been considered market risks: a yes to Brexit, Trump’s election and Renzi’s resignation following the rejection of his proposals for constitutional reform. Despite all this, continental European stock markets made modest progress in Euro terms in 2016 (while delivering strong gains in sterling terms) and have continued to rally in the first quarter of 2017.
European markets today: Reasons to be cheerful
Most importantly, the outlook for company earnings has improved as confidence in global growth has risen. After a number of years during which European companies have delivered little in the way of earnings and dividend growth, analysts are now forecasting double digit earnings growth for 2017 and 2018. Earnings revisions ratios turned positive last summer and have not been this positive in 5 years.
Earnings are now being revised up!
Source: Fidelity International, Datastream. March 2017
The question is: how much of this good news is already priced in by the market, following its strong performance? Absolute valuations in continental Europe are high by historical standards. If, however, current multiples hold, perhaps partly thanks to continued ECB support, then investors can look forward to satisfactory returns driven by the combination of dividend yield and dividend growth.
"Earnings revisions ratios turned positive last summer and have not been this positive in 5 years"
– Sam Morse, Fidelity European Values
Reasons to be cautious
A high level of valuation leaves the market vulnerable to exogenous shocks. Continental Europe sees a busy political calendar in 2017 with French, German and, possibly, Italian elections to look forward to, not to mention the on-going Brexit negotiations. The main risk, however, would be any hiatus in confidence in the current economic improvement which is buoyed by optimism that Trump’s promises of tax cuts and infrastructure spending will come good and will boost the US economy. There is a risk, of course, that if his programme fails to deliver against what appear to be fairly high expectations, investors could lose enthusiasm and turn more cautious.
"The main risk would be any hiatus in confidence in the current economic improvement which is buoyed by optimism that Trump’s promises of tax cuts and infrastructure spending will come good and boost the US economy"
– Sam Morse, Fidelity European Values
There are some warnings signs that sentiment is extended. One example might be the flurry of new issues, some at high, and, possibly, quite speculative valuations, given immature business models. As always, markets can get ahead of themselves and as Warren Buffett famously advised: “Be fearful when others are greedy”.
Stock picking opportunities
Against a backdrop of relatively high valuations, by historical standards, and increased market optimism, especially in the more cyclical sectors, selectivity remains important. Personally, I remain focused on attractively valued companies with good steady long-term dividend growth prospects, through economic cycles, which also enjoy strong balance sheets and good cash generation. These sorts of companies may, in buoyant times, appear less exciting to investors than more leveraged companies that are sensitive to the economy but they will prove more robust when some of the excitement evaporates. These sorts of companies have suffered a relative de-rating in recent months as investors have focussed on the recovering fortunes of riskier companies. A rising tide lifts all boats and valuations now appear more balanced across the market. Companies such as Fresenius Medical Care or Nestle, for example, now appear to be more attractive on a relative basis given the sustainability of growth in the longer term.
UK triggers Article 50:
Managers comment on outlook for UK & Europe
On Wednesday 29 March Article 50 of the Treaty of Lisbon was triggered, formally notifying the EU that the UK intends to withdraw from membership and starting the clock for leaving negotiations. The AIC has collated the views of investment company managers on whether this will impact how they manage their portfolios and the outlook for UK and European markets.
UK manager views
Harry Nimmo, Manager, Standard Life UK Smaller Companies Investment Trust said: “Essentially I’m indifferent to the triggering of Article 50. Our investment process starts with stock selection. Our focus is on companies exhibiting growth, quality, earnings visibility and business momentum. History has demonstrated that our kind of lower risk growth-orientated companies can generally flourish regardless of the direction of macro-economic change. Indeed, our companies tend to come into their own in uncertain economic times. They are often outward looking with business models that thrive beyond our shores, irrespective of exchange rates and trade barriers.”
Harry Nimmo, Standard Life UK Smaller Companies
Jonathan Brown, Manager, Invesco Perpetual UK Smaller Companies said: “In simple terms, the UK's vote in favour of Brexit cast us into a period of high political and economic uncertainty, presenting unknowns of a scale we have not experienced in the market for some time. Since then, the UK economy has shown remarkable resilience to the challenges ahead, with fears around consumer spending, recruitment and domestic business proving largely unfounded. Consumer spending and the service sector continue to drive the UK economy, despite some decline in business investment. The jobs market remains robust, although we expect inflation to squeeze discretionary expenditure as we progress through the year. Retail sales volumes fell in January, so there is some evidence of this already and, in spite of higher inflation expectations, the BoE seems unlikely to raise interest rates in the short term.
“Both the stock market and sterling moved very sharply last summer in anticipation of longer-term disruption, but we feel some of these moves have been too sharp, allowing us to reshape our portfolios in areas we perceive to be oversold. Where the market has had concerns about a stock’s domestic exposure, business conditions have often remained largely unchanged, presenting longer-term opportunities.
"As the UK government begins its formal Brexit negotiations with EU members, we remain optimistic about the road ahead"
– Jonathan Brown, Invesco Perpetual UK Smaller Companies
“As the UK government begins its formal Brexit negotiations with EU members, we remain optimistic about the road ahead; we have a dynamic economy which has adapted to change before – and is now primed to adapt again to whatever change is thrown at us. Sterling will remain a key instrument to watch over the near-term, as movements in currency will continue to impact the extent of the wider market response. Political events in the United States and Europe have added an additional twist to the outlook for major global currencies, and we have observed the market thinking more carefully about currency implications.
Jonathan Brown, Invesco Perpetual UK Smaller Companies
“Ultimately, we don't manage money on a three-month view or a six-month view but in the best long-term interests of our clients. We would urge investors to recognise that we will endeavour to make considered judgments on the basis of the facts as they emerge. We will not be making changes to the methodology we have used for many, many years to build our portfolios, nor departing from the processes we deploy to analyse, understand and respond to investment opportunities across UK equity markets.”
European manager views
Stephen Macklow-Smith, Manager, JPMorgan European Investment Trust said: “A huge amount depends on the type of agreement that can be reached. In the short-term nothing has changed, nor will it until March 30th 2019, two years after the triggering of Article 50. In the medium-term, however, companies are likely to take a precautionary approach to ensure they are not blindsided by any collapse in negotiations. We have already seen, for instance, signs that banks are beefing up their presence in the Eurozone which, in the short-term, will add modestly to their costs relative to the situation without the uncertainty of the negotiations.
"A huge amount depends on the type of agreement that can be reached. In the short-term nothing has changed, nor will it until March 30th 2019, two years after the triggering of Article 50"
– Stephen Macklow-Smith, JPMorgan European Investment Trust
“The bottom line is that if no deal is possible, that will have a negative impact on growth in both the UK and the EU. Although the impact will be that much less for the EU given that they will all remain members of the Single Market and will continue to enjoy an uninterrupted trade relationship with other countries outside the EU which have an existing trade agreement.
“We continue to find a number of opportunities in the more cyclical areas of the stock market and believe that as global reflation is increasingly evident, the tailwinds for growth will improve and earnings in more cyclical sectors will benefit.”
"In Europe signs of an improving economy, emerging inflationary pressures, and a long-overdue recovery in corporate earnings have been overshadowed by the UK’s vote to leave the European single market"
– European Equities Desk at Henderson Global Investors
The European Equities Desk at Henderson Global Investors, which includes Henderson European Focus Trust, Henderson EuroTrust and TR European Growth Trust said: “In Europe signs of an improving economy, emerging inflationary pressures, and a long-overdue recovery in corporate earnings have been overshadowed by the UK’s vote to leave the European single market. While the referendum result takes the EU into uncharted territory, nothing has yet changed and little is known of how negotiations will proceed. Political concerns more broadly remain one of the more significant risks to the future of the EU, with important elections in France and Germany this year and far right anti-Europe parties expected to poll a significant number of votes.
“The uncertain impact of politics aside, the recovery in Europe seems to be on track, reflected in a consensus forecast of 1.5% economic growth this year. The European Central Bank is unlikely to pull back from its accommodative monetary stance over the short-term and an improving economic climate may lead to more relaxed government spending. Unemployment in the euro area also fell to its lowest level since 2009 in January 2017. This tightening in the labour market makes it more difficult for firms to recruit workers but should support consumer confidence. European equities remain attractively priced relative to other regions, particularly the US. Any improvement in earnings growth in Europe is also likely to be a catalyst for gains.”
Stephen Macklow-Smith, JPMorgan European Investment Trust
Annabel Brodie-Smith, Communications Director of the Association of Investment Companies said: “The triggering of Article 50 starts the process but it will still be a while before we fully understand the implications of the decision to leave the EU. Reassuringly, investment companies have a long history and have weathered the First World War, the Great Depression, the Second World War, the rampant inflation of the 1970s and the financial crisis.
“Investment companies are just as relevant for investors today as they ever were, having strong long-term performance. They offer a broad variety of sectors, risk profiles and geographical exposure. Investors need a balanced portfolio and to take a long-term view as it’s important not to overreact to short-term market movements. If investors have any concerns they should speak to a financial adviser.”
