ECB warns UK equities most vulnerable to a crash

UK shares are expensive and more vulnerable to a crash than equities in most other major global markets, the European Central Bank has warned.

Figures in its Financial Stability Review report published this week showed that the UK was the most overvalued market in October, followed by the US, Europe, emerging markets and China.

It used the cyclically adjusted price to earnings ratio to point out “valuation measures… are in some regions hovering at levels which, in the past, have been harbingers of impending large corrections.”

It says the measure is “arguably the best indicator of valuation based on earnings”.

It said the prices in some equity, markets have begun to signal stretched valuations.

AJ Bell investment director Russ Mould says looking at market capitalisation to GDP as a metric the UK is “pretty expensive”.

He says: “It is about 120 per cent market cap to GDP which is basically as high as it is ever been.

“You can justify that because corporate profits at a percentage of GDP have never been higher so if you believe that corporate profits will stay where they are or even go up then you are not going to be too worried.”

As the ECB pointed out with its warning, if there's going to be a slowdown, down turn or recession in the UK that is “clearly potentially very problematic”, Mould says, because of the earning support for that high valuation.

However, Mould says UK shares are cheap on a dividend yield basis or relative to bonds.

He says: “If you look at dividend yield in the UK it's at around 4 per cent and even after the big rise in yields, the gilt yield is 1.4 per cent so that is a 250 bps premium, which is historically extremely high. So on a yield basis or relative to bonds, the UK is actually very cheap.”

The yield argument will remain “quite compelling”, says Mould unless bond yields zoom upwards or there are big dividend cuts.

He says: “We only had two big FTSE 100 companies cutting their dividend this year which is Sainsbury's and EasyJet against about 12 last year.

“So dividend yields will provide support even if cover is thin and unless the economy gets into recession UK equities will prove relatively resilient but whether they'll make massive amounts of progress or not, I am not too sure either, they'll need a big tailwind from exports and from oil, the dollar and miners to make substantial progress and ultimately the banks.”

Meanwhile, investors continue to shun UK equities with the region seeing outflows of £620m in September, compared to £162m in August, according to the latest figures from the Investment Association.

'US most expensive on all metrics'

The US followed the UK in terms of overvalued stocks, the ECB shows.

In its report, however, the ECB shows the US was the most expensive on all the three common price to earnings metrics it used, which are last year's reported earnings with a sample starting in 1985, forecast earnings for a year ahead starting from 1990 and the cyclically adjusted price per earnings ratio with a 10-year view starting in 1985.

Mould says: “The US is expensive on market cap to GDP, relatively expensive on forward earnings. The S&P 500 yield is now basically the same of the 10-year Treasury so that element of support is not as strong as it was either before the index offered a yield premium, which is historically extremely unusual.”

Conversely, emerging markets are cheap because they've outperformed this year but they've underperformed for four or five years previously, says Mould.

He adds: “If you look at price to book value, emerging markets are not at the bottom end of their range but still quite low, but they are still at the best valuations than Europe or the US.”

However, emerging market currencies continue to be under stress, he says.

“Asian governments learned their lessons in the 1990s. Asian corporations piled a lot of debt and that is a potential concern but if you look at valuations, EM is one place to go and the other place is Japan”, Mould says.

Japan is almost a “stock picking delight” for investors, Mould says, despite the macro data “doesn't look very good at all”.

He says: “In Japan in cheap in terms of earnings, and price to book value specifically as a lot of book value is in cash so you have tremendous downside underpinning that your problem with Japan is that the economy isn't great but that said, corporations are focusing more on improve governance and shareholders returns giving back 5 per cent a year back to the market in dividend yield and share buy backs.”

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