Slower US economic growth leading to higher earnings risk and excessive stock valuations is “a potentially dangerous combination” for global investors through the rest of 2019, according to Neil Woodford.
But one market Woodford, manager of the Morningstar Bronze-rated Woodford Equity Income fund, is particularly bullish on is, unsurprisingly, his domestic one.
While the star fund manager expects the world economy to continue to slow markedly, which will be “felt most acutely in Europe, emerging economies and China”, an eventual softer Brexit will be a catalyst for outperformance for UK shares.
In his latest monthly update, Woodford notes he believes the prospect of a US-China trade deal has blinded investors to the “very significant issues” facing them.
Slower growth is the major issue facing markets, particularly in the US, while a significant deterioration in global US dollar liquidity is set to be a further headwind for markets approaching the summer months.
“This may be the catalyst for a much less benign market environment than that which we have witnessed in the first four months of the year,” explains Woodford.
For the UK, though, he is more upbeat. Paralysis in Westminster, he says, has substantially increased the odds of a softer Brexit. “A no-deal is now, in my opinion, extremely unlikely.” While Theresa May’s deal getting through Parliament is still less likely, Woodford puts a higher probability on a softer outcome, involving some form of long-term and close relationship with the EU.
Should this happen, Woodford foresees “a long overdue and significant rally in sterling”, which will “have a meaningful impact on the UK stock market”.
“It should at last liberate investors to start to acknowledge the underlying robust performance of the UK economy and the profound undervaluation of companies exposed to the UK economy,” Woodford claims.
“At the same time, these developments will also prompt the market to start to address the significant earnings and valuation risks in parts of the index where investors have significantly increased exposure over the last two years.”
The rest of 2019, Woodford predicts, will be very interesting, “and 2020 maybe even more so”.
Woodford Pledges to Continue with Valuation
The majority of Woodford’s latest monthly update for investors focused on his process, which has come under scrutiny due to his funds’ continual underperformance since launch.
Since his Equity Income fund was launched in June 2014, it has returned just over 10% - well below the 32% gained by the FTSE All-Share in that time. His newer Income Focus fund, launched in March 2017, has lost 18% versus a gain of 8.5% from the FTSE All-Share.
Woodford pledged to stick to his valuation-based investment approach, explaining that valuation is, in the long term, “the most reliable predictor of future investment return”.
To highlight this point, had you invested in the UK stock market on December 31, 1974 at a price/earnings ratio of just 4 times your subsequent real return over the next 10 years would have been 16.8% a year.
In contrast, if you had invested in the UK stock market on December 31, 1999 at a P/E ratio of 28.6 times, your subsequent real return over the next 10 years would have been barely positive – at just 0.2% a year.
“Nothing in investment comes close to the predictive power of valuation with respect to future returns,” Woodford concludes. While this may be profoundly intuitive, even common sense, these valuation principles don’t always guide investor behaviour, he laments.
“When financial markets lose touch with valuation principles, accidents always happen and crowded trades always blow up. This has happened throughout financial market history and has affected many different assets as diverse as tulip bulbs, property and of course most frequently, equities.”
“Ultimately, the inevitability of a correction in overvaluation is certain. The timing of that correction, unfortunately, is not.”
As a result, he explains, investors tend to get sucked into asset bubbles, losing their perspective on valuation and following the crowd into momentum-led stocks that have risen in price and, typically, out of those that have fallen, insensitive to valuation.
This is likely to be successful in the short term, because the majority are doing the same thing and bumping these share prices higher. But “chasing valuation because the majority of investors are doing the same thing condemns that majority to a rude awakening and, more importantly, poor future returns”.
