U.K. Stocks: Leveraged Long Positions Warranted

The FTSE100 offers a relatively high dividend yield and scope for strong dividend growth over the coming years, which suggests leveraged long positions are warranted amid a backdrop of deeply negative real bond yields. From a 10-year perspective, we would have to see either a continued collapse in dividends or a further decline in valuations in order for U.K. stocks to fail to exceed the yield on gilts in total return terms. Much more likely is double-digit nominal returns with the help of high levels of inflation.

We have noted on numerous occasions over recent months how low interest rates do not justify high equity valuations. In “Faith In The Fed’s Ability To Support Stocks Is Unfounded,” we showed that there is no correlation between real interest rates and equity valuations, while we explained in “Stimulus And Stocks: Beware The Unintended Consequences” the theory as to why that is the case. However, when equity valuations are cheap in their own right, as they are in the U.K. currently, deeply negative real interest rates raise the prospect of outsized returns for leveraged investors.

FTSE100 Dividend Yield vs. 10-Year Government Bond Yield, %

Source: Bloomberg

Double-Digit Annual Gains Likely Over Next Decade

The trailing dividend on the FTSE100 has proven to be very closely correlated with subsequent 10-year returns over the past 50 years, as the chart below shows. From a historical perspective, the current dividend yield of 4.0% is consistent with 10-year total returns in excess of 10% annually. The current yield is in line with the FTSE100’s long-term average, while average 10-year returns have been around 12% per year, ranging from -1.4% per year from 1999 to 2009 to +30% per year from 1974 to 1984.

Source: Bloomberg, Author’s calculations

It is also worth noting that the 4.0% trailing dividend yield reflects the 40% collapse in payouts over the past year. Trailing 12-month dividends are at their lowest level since 2012, and when adjusted for the retail price index, real dividend payments are no higher than they were 25 years ago. Even if dividend payments remain at these multi-year lows for another decade in real terms, we should still see solid dividend growth in nominal terms simply due to the ongoing debasement of the pound.

Source: Bloomberg, Author’s calculations

Inflation Should Provide A Major Helping Hand As It Did In The 1970s

In order for the FTSE100 to deliver double-digit gains over the next decade amid a 4.0% dividend yield, we would have to see dividends grow by over 6% per year absent any increase in valuations – the price investors are willing to pay for any given dividend yield. We see this as more than likely considering the strong prospect of high inflation over the coming years. As was the case in the 1970s-1980s, high rates of inflation would provide a major tailwind for dividends and, therefore, total returns over the next decade.

FTSE100 Dividend Yield And 10-Year Breakeven Inflation Expectations, %

Source: Bloomberg

U.K. 10-year breakeven inflation expectations – a market-implied average rate of retail price inflation over the next decade – are currently 3.1%, and considering the exponential rise in money supply and government debt, this may well turn out to be a major underestimation. Even if we assume investor expectations are correct and the general price level rises 3.1% per year, this should gradually feed through into higher dividends, particularly given the high weighting of energy, materials, consumer staples, and healthcare stocks in the FTSE100, which together make up over 50% of the index. The high weighting of defensive and inflation-sensitive sectors should allow companies to pass on higher prices to U.K. and international consumers. Energy and materials, with a combined weight of almost 20%, should perform particularly well should inflation pressures rise substantially.

Excess Returns Over Bonds Will Be Huge

While we expect to see double-digit annual gains in the FTSE100, even meagre returns would be sufficient to cover interest payments on 10-year debt given the current gilt yield of 0.2%, meaning leveraged investors are likely to reap strong returns. While the current dividend yield is broadly in line with its long-term average, it is extremely elevated relative to long-term bond yield, as the chart below shows.

Source: Bloomberg, Author’s calculations

The current spread between the FTSE100 dividend yield and gilt yields even exceeds that seen in 1974, when stocks yielded almost 10%. An increase in valuations allowed stocks to outperform bonds by around 20% per year back then, which we do not expect to be repeated, but it would take a massive decline in valuations for leveraged investors to lose money.

This Looks Like A Good Entry Point

Even if 10-year expected returns are high, they can always become higher thanks to declining valuations. However, the near-term outlook appears to align with the long-term outlook as the internal market picture continues to strengthen. The market’s underperformance relative to most of the rest of the world over the past few months reflects the dire performance of a small number of stocks with a high weighting in the index.

FTSE100 vs. Equally-Weighted FTSE100

Source: Bloomberg

The equally-weighted FTSE100 has dramatically outperformed reflecting a recovery in risk appetite. Furthermore, the FTSE100 is a highly contrarian play at present, with the October Bank of America Fund Manager Survey showing investors are more underweight U.K. stocks relative to their own history than any other major asset class excluding Energy.