With the triggering of Brexit already more than 50 days old, the two-year window to officially divorce from the European Union feels more akin to a Usain Bolt sprint than a Mo Farah run.
As sprinting tends to be more exciting than the longer-distance sports, it is understandable that the attention of market participants appears to be exclusively focused on the Brexit “event”. Yet, in reality, returns to investors will be driven by underlying fundamentals over a longer time horizon and it seems irrational to expect 65m people to slump to their knees before they cross the finish line. Or, to put it another way, we must adopt the attitude of the marathon runner rather than the sprinter.
As any experienced marathon runner will attest, it is the consistent maintenance of energy levels that gets the best time. Both the government (via fiscal measures) and the Bank of England (via monetary measures) will have a big role to play in this respect, as they want to keep the British population optimistic enough that they can see the big picture, but not so overly optimistic that they spend all their fuel. While in a marathon we call it “hitting the wall”, in economic terms we call it a “recession”.
Many were expecting the economy to hit the wall in the aftermath of the Brexit vote, but have been pleasantly surprised that the economy has continued to run near its desired speed. In fact, the UK economy has thus far been quite resilient, growing by 0.5 per cent in the third quarter of 2016, 0.7 per cent in the fourth and 0.3 per cent in the first quarter of 2017 – roughly in line with the average quarterly growth rate since 1955 (average has been 0.61 per cent). This, along with a much lower sterling, has seen the UK equity market outperform Europe since the referendum on leaving.
The problem is that we do not know the amount of energy a marathon runner will have left at the 22-mile mark. We can gauge the way the runner looks – but more often than not, a blow up can emanate from left field. One cannot get away from this fundamental uncertainty when running for the long-term and the same can be said for financial markets.
Therefore, while everyone is closely watching for any changes in the way the runner looks (any changes to the economy in the short term), they could be better placed paying closer attention to the fuel intake and the amount of energy the runner expends relative to that fuel. In financial market terms, we know this as the “fundamentals” and “valuations”.
The fundamentals are the baseline that provides the energy or sustenance for the market to keep running beyond the finish line. For UK investors, it is things such as return-on-equity, dividend sustainability, payout growth and profit margins. Without them, the UK investor risks falling flat on their face.
Valuation, on the other hand, is the amount of energy a runner expends relative to the fuel they have. We have all seen those dreaded moments where a runner gets the fuel intake right, but goes too hard during the big event and runs out of steam. In financial terms, this can be best gauged as the price relative to the fundamentals, including an assessment of ratios such as the cyclically adjusted price to earnings (CAPE), price to free cash-flow (PCF) as well as any other value metric. The idea is that the harder a runner perspires relative to their fuel, the more likely they are to run out of energy.
