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Good morning. It’s Friday! Next week is Thanksgiving! Unhedged is feeling giddy. So are American shoppers and retailers. But it is important to keep a balanced perspective, so we’re having a look at UK stocks as well. They are not giddy.
UK stocks are cheap, but not attractive
Here is a maudlin Morrissey song of a chart:
That’s the performance of large-cap UK stocks relative to their American cousins, going all the way back to the 1980s. It features two plateaux (1983-93 and 2004-10) and two big slides. The second slide continues to descend today, which has made UK stocks look attractively cheap. The forward price/earnings ratio of the S&P 500 is 22, compared with the FTSE 100’s 12, according to Bloomberg.
Zooming in on just the past decade, the underperformance of the UK index clearly has a lot to do with the underperformance of value stocks. Banks, materials, energy and industrials have a heavy weight in the FTSE. Here is the relative P/E valuations of the FTSE and the S&P, charted against the relative valuations of the Russell value and growth indices:
The UK is relatively cheap in large part because value stocks are cheap. So, if you wanted to bet on a value bounce (not a mad bet, at a time when stocks in general look expensive and rates are threatening to rise) you might buy the FTSE to do it.
But to the degree that UK stocks are exposed to the economy of the UK — as its banks, retailers and utilities are, for example — that might be a mistake, because it’s economy is about to run into some quite specific problems.
That, in any case, is the argument of Absolute Strategy Research, which has just downgraded UK stocks. Their argument turns on labour shortages, inflation and valuations. Here is their chart of the percentage of UK companies that say a lack of skilled and unskilled labour is limiting production. The cumulative percentage is at levels last seen in the 1970s:
This is important for investors because labour shortages are often followed, at a lag of half a year or so, by falling stock valuations:
ASR explains this correlation as follows. A market with a labour shortage can return to equilibrium in two basic ways: wages can rise or demand can fall. Both outcomes are a drag on profit growth. Both outcomes might also lower real interest rates, weakening the pound, creating an additional risk for international investors in UK stocks.
Why would any of this be unique to the UK? The US has a worker shortage too. Half of US small businesses have unfilled positions, compared to 40 per cent before the crisis, according to the National Federation of Independent Business. To a degree, the point can indeed be generalised: sales growth and wages are strong now, but when growth slows, wages are likely to stick, hitting margins globally (see the note about US retail, below).
The UK is different, though. It is a small, open economy, while the US is large and mostly closed. This has made the Britain historically more vulnerable to inflation. And its labour shortage is especially acute because of Brexit. Here is ASR’s chart of UK employment by worker origin:
Brexit has driven international workers out of the UK (that was part of the point). And the policy response to that fact has been inadequate, as ASR points out:
“Although the UK government offered 5,000 visas for foreign [heavy goods vehicle] drivers and 800 visas for non-UK meat workers, the Road Hauliers Association estimates a shortage of 100,000 drivers and the British Meat Processors Association estimate shortages of 15,000 meat workers.”
Nor can monetary policy help much with the labour problem, which is about inadequate supply, not excess demand. If ASR is right, UK stocks may underperform even value stocks in the next few years.
Inflation is high. Finding and keeping employees is hard. Supply-chain pain lingers. You’d expect all this to result in higher prices and lower sales. Well, prices are higher, but sales are higher still: US retail sales rose 1.7 per cent last month.
The last time we checked in on the retail industry, we argued that quality companies would stand out as margins diverged. To an extent, third-quarter earnings have borne that out. Revenues have been strong almost across the board, but margins have been more uneven. Compare gross margins at the largest DIY sheds with the biggest of the big boxes:
Share prices are diverging too (note at the far right that Wall Street was not amused by the margin problems Target and Walmart reported this week, despite solid revenue performance):
In conference calls this week, Target and Walmart executives chalked up margins compression to higher input, transport and labour costs. Home Depot execs, whose company had declining gross margins in 10 of the past 11 quarters, sounded relieved with near-flat margins. Meanwhile, the chief executive of Lowe’s sounded triumphant:
“I couldn’t be more proud of the team’s efforts . . . to increase gross margin, increase operating income and also sustain competitive in-stocks in the midst of the most complex global supply chain environment that any of us have operated in.”
Rahul Sharma at Neev Capital, our favourite retail analyst, notes that Lowe’s and Home Depot can protect margins in part because they compose a home-improvement duopoly, with 80 per cent joint market share. That means pricing power.
Hotter competition in the big-box game means they feel the margin pressure first. Industry wide, though, margins are up. Even smaller chains such as Macy’s and Abercrombie are doing well. Here’s what margins look like for S&P 600 small-cap retailers:
We suspect this won’t keep up, and more retailers will soon be having Target-like margin problems, because it is hard to maintain sales growth and even harder to make costs go into reverse.
Sharma sums up:
“There is pent-up demand out there and everyone benefits. There’s been this narrative that Covid winners (who won in a stay at home economy) would meet their comeuppance this year as sales normalised. All four big retailers [Lowe’s, Home Depot, Walmart Target] reporting today were in this category [and yet their sales were strong]
“But not everyone will do so well once we move past this period of booming demand.”
Companies are spending big to keep shelves stocked — choosing pricey air freight over cheap, congested ocean shipping, for instance. Ditto on raising wages to attract staff. After the holiday euphoria subsides, expect margins to compress as these costs prove sticky. (Ethan Wu)
One good read
Team transitory has no better spokesperson than the FT’s Martin Sandbu.