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Have the stars finally aligned for UK equities?

21 May 2021

Trustnet asks market commentators for their outlooks on the UK following an apparent shift in investor sentiment and overall performance.

By Eve Maddock-Jones,

Reporter, Trustnet

Following an extended period out in the cold, ‘positive’ is now the overall outlook that many investors appear to have for the UK at the moment, as conditions turn increasingly supportive for the domestic market.

For several years, the UK equity market has been avoided by investors due to the uncertainty created by Brexit and a poor initial response to the coronavirus pandemic. It was consistently the ‘consensus underweight’ in Bank of America’s closely watched Fund Manager Survey and UK equity funds endured years of heavy outflows.

But the UK has seen a shift in both performance and investor sentiment in recent months after the two major headwinds of Covid-19 and Brexit were removed. In addition, it has benefited from a market shift into cyclical and value stocks, which are well-represented in the UK.

Ben Yearsley, co-founder and director at Fairview Investing, said the UK started 2021 with “a reasonable degree of hope” driven by ‘Vaccine Monday’ in November 2020.

The rollout of several effective Covid-19 vaccines meant that the UK could glimpse a path out of the pandemic it had been struggling to get a handle on. The UK vaccination programme has progressed much quicker than those of many other countries.

“This is important for one good reason (excluding the health benefits obviously) in that it has given the UK consumer and businesses much needed confidence,” Yearsley (pictured) said.

“Confidence to spend, confidence to invest.”

On the Brexit front, uncertainties over the UK’s life outside of the European Union had been a major cause for concern since the 2016 referendum. FundCalibre research director Juliet Schooling Latter said this had effectively made the UK an investment “pariah”.

But now with a Brexit trade deal agreed in late December “the UK is starting to be seen as investable again”, Schooling Latter said.

That being said, there is still some gap to cover to get levels of investment in the UK back to where they were pre-Brexit, according to Jason Hollands, managing director of Tilney Investment Management Services, suggesting scope for further outperformance.

“In my view there is still potentially quite a lot distance still to go in rebuilding weightings to UK equities, which is, after all, the fourth biggest country globally by equity market-cap,” he said.

All of this has culminated in the UK looking to have a strong recovery, according to the commentators, who recently highlighted six funds to capture the UK’s recovery.

“Despite lockdown, despite Brexit, the UK economy has returned to growth. I think this recovery, both economic and market, has legs,” Yearsley said.

“The concerns and issues of the last few years have largely gone and coronavirus appears on the wane. So why shouldn’t the massive valuation gap between UK plc and World plc start to narrow? I picked the UK at the start of the year and stick by this.”

A large part of this positive UK sentiment is the recent market rotation into value and cyclicals, both of which the UK market has a bias towards.

This characteristic dampened the UK’s returns versus other more growth dominant markets in previous years and saw UK indices lag during the initial Covid-19 rally.

Performance of UK versus global indices in 2020

 

Source: FE Analytics

But as markets generally move into a recovery phase following global vaccine rollouts, this caused a rotation into less cyclically sensitive assets – and the UK has been a beneficiary.

Performance of UK versus global indices year-to-date

 

Source: FE Analytics

Rob Morgan, pension and investment analyst at Charles Stanley Direct, said this characteristic make the UK the “obvious choice for investors wishing to hedge against inflation”.

Increased inflation expectations appear to be one of the dominant market concerns at the moment. This week the UK’s latest CPI (consumer price index) data revealed that inflation had more than doubled in the UK between March and April, rising from 0.7 per cent to 1.5 per cent.

Morgan said: “The UK market has significant exposure to areas that have fared pretty poorly over the past decade – energy, commodities and banks.

“However, in an environment of economic recovery these could perform much better. Their fortunes are tied to global growth and would do particularly well if inflation exceeds expectations. Already we are seeing mining stocks perform exceptionally well as increasing demand is coming up against supply constraints. I think the outlook remains bullish for commodities, though less so oil as structurally the use of the most polluting fossil fuels will continue to decline.”

Another appealing element is not just the type of stocks the UK predominantly holds, but the marked valuation discounts they’re running at.

Due to the aforementioned years of investor dislike, a valuation discount has built up compared to other developed markets. This may now become more appealing to investors.

“As the team behind the Artemis Income fund pointed out recently, this valuation discrepancy is not confined to the value part of the market, there are also growth stocks that are a match for their US-listed peers yet whose shares are anomalously cheap by comparison,” Schooling Latter (pictured) said.

Morgan added to this, saying: “It is also possible that some investors will continue to migrate to cheaper areas as they can now find the sorts of growth rates that was the preserve of tech giants and other structural growth areas such as healthcare.

“In doing so the UK will likely come onto their radar.”

Another strength of the UK market looking ahead is the rehabilitation of its dividends and income space.

Prior to the pandemic the UK was a major hub for income investors but this area of the market saw a substantial negative impact due to the pandemic as businesses were forced to cancel or reduced dividends to cover balance sheets during the initial crisis.

Now that non-essential businesses have reopened and lockdowns eased the dividends space has markedly improved.

Morgan said: “At a company and a sector level it is a disparate picture but we are starting to see a concerted rebound from the savage disruption last year.

“A dividend yield of around 3-4 per cent from UK equities in 2021 is a realistic expectation, and is a sustainable base for dividend growth. In a world of very low interest rates it seems an attractive starting point.”

There was one note of concern, however, namely around inflation and the negative impact it could have.

Schooling Latter explained: “The one word of caution here is that the UK tends to be a ‘receiver’ of inflation as it is service-led and we import raw materials and food. So we can suffer from cost-push inflation. If sterling was to weaken and inflation be more than a summer phenomenon, it could dampen the recovery.”

Peter Toogood, chief investment officer at The Adviser Centre, added: “UK equities remain under-owned by global asset allocators and have been since Brexit.

“The poor initial response by the government to Covid-19 reinforced the belief that an underweight stance was justified. The relative success of the vaccination experience, plus the sheer scale of the fiscal and monetary response by the UK authorities, gave investors pause for thought. Clearly, minds have been changed as investors seem excited by the possibility of an economic rebound.

“This rebound also has legs on the assumption that the UK Treasury does not take premature action to raise taxes and snuff out the recovery. The exchange rate remains competitive and the UK economy has a large output gap, so there is room to grow before inflation rears it ugly head!”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.