Outlook 2019: UK equities

• The possibility of a “no deal” Brexit has created uncertainty
• Investors have shunned UK stocks as a consequence of Brexit
• Stock selection will remain key
• The longevity of the current bull market is a potential source of concern

Introduction

More often than not, global developments set the tone for UK equities and the market gyrations seen in the fourth quarter of 2018 are a timely reminder of this. The major domestic issue of Brexit has taken a back seat. Instead, the driving forces are international; including US-China trade tensions, European political uncertainty, and the end of quantitative easing/rising interest rates.

Global trends like these will continue to be crucial. But so will Brexit, with many potential pitfalls in the run up to and beyond the UK’s scheduled departure from the EU on 29 March 2019. The UK government has negotiated a “withdrawal agreement” with the EU. However, if parliament rejects the deal, and a delayed Brexit is not agreed the UK will be leaving the EU on 29 March 2019 without a deal, with the risk of a UK recession.

Against this backdrop, two of our fund managers who cover different areas of UK equities explain how they’re looking at the UK stock market heading into 2019.

As a consequence of Brexit, UK domestic-focused companies have significantly underperformed those companies which generate their earnings overseas. Sterling weakness has been a major driver of this as overseas earnings become more valuable when brought back to the UK when the pound is weak. However, the underperformance has also been in large part due to UK domestic companies suffering a “de-rating” (see below for explanation) amid fears the UK economy would grow at a lower rate outside the EU.

When we look at the dividend yield of the UK stock market at 4.5% (see chart below) we see it's at an equivalent level to that seen before and after the peak of the global financial crisis (GFC) in 2008/09. However, we don't believe we are likely to see a recession in the order of magnitude experienced following the GFC. If we do see a recession, we would expect it to be local to the UK (possibly the result of a “no deal” Brexit), rather than global, albeit world economic growth looks set to moderate in 2019. This gives us a degree of comfort that this elevated yield is sustainable (rather than a signal of impending distress) as the large majority of UK stock market dividends derive from overseas.

The extreme level of pessimism towards the UK stock market also becomes apparent when you study the dividend yield gap between UK and global equities. The UK stock market has historically offered a higher yield than other regions, however the premium is now at its most elevated in almost 20 years, at a level not seen since the 1999/00 dotcom bubble (see chart below).

As 2018 comes to a close many market commentators are rightly drawing parallels to previous occasions when the market cycle and “business cycle”1 were in more advanced stages. The pick-up in volatility certainty reflects a growing nervousness around the outlook.

Again, however, we take some comfort in the fundamentals. The short-term outlook for underlying UK dividend growth (excluding both special dividends and exchange rate movements) has improved, due to the strengthened pay-out ratios resulting from rising commodity and oil producer profits. Meanwhile, that other big driver of UK dividends, the banking sector, is finally returning to form 10 years after the GFC.

Should a “no deal” Brexit be averted, there would likely be an upwards movement in sterling and a re-rating of the market. This would be particularly beneficial to those UK domestic companies that have suffered a severe de-rating2 over the last two and a half years. UK-focused banks, property companies, housebuilders, consumer discretionary areas (general retailers and leisure companies), food retailers, media agencies and utilities are all trading on depressed ratings. This is clearly seen in a range of valuation metrics, including price-to-earnings (P/E) ratios, which for some of these sectors are now in single digits.

With the plethora of forecasts since the EU referendum, what has actually happened to the UK economy since June 2016? Well, the economy has continued to expand at a steady pace (and ahead of expectations) against the backdrop of a very low unemployment rate and rising wages. The country’s fiscal position has also recovered as tax revenues have picked up, further underlining the resilience of the UK economy. We are, therefore, cautiously optimistic about the future.

The chancellor significantly loosened the purse strings in the Budget, in what the Office for Budget Responsibility has described as the “largest discretionary fiscal giveaway” since the economic advisory body was created in 2010. This comes at a time when nominal wages have continued to rise (up 3.2% in the three months to September, the fastest rate since December 2008), while a moderation in inflation has seen the return of real wage growth.

Historically there has been a positive correlation between real wage growth and real retail sales, as illustrated by the chart below.

It is telling to us that, despite their depressed levels of confidence in the general economic outlook, the surveys reveal that consumers remain positive about their personal financial situation. We certainly see evidence from our portfolio holdings of consumers willing to spend. The key challenge remains identifying the beneficiaries of the increased spending, at a time that structural changes impacting the UK high street and other consumer-facing sectors now seem to be accelerating.

In this regard, it’s our view that the odds could be skewed in favour of investors in UK small and mid-cap (smid) companies. This is an area of the market packed full of companies taking advantage of new technologies and the internet to drive growth, disrupt and take share from sector incumbents. In a fast-evolving world, smids are generally better able than large caps to capitalise on the opportunities as they tend to be more dynamic, and have a small base from which to achieve growth.

We have identified a number of specialist retailers that are bucking the decline in the UK high street. They encompass a whole range of sectors, from cutting-edge “athleisure” fashion to homewares retailing. Many of them are in the foothills of “multi-channel” strategies, as they discover the right mix of in-store and online experience to maximise growth. Others take in niches such as pet supplies or casual dining, where management teams are seizing the initiative, making changes and turning performance around. And there are plenty of companies benefiting directly from the travails of sector peers.

At the same time it should not be forgotten that the revenues of the FTSE 250 are evenly split between overseas and domestic sources, so smid investors stand to benefit both from exciting overseas growth opportunities, and the highly depressed sentiment towards UK domestics. Given the growing divergence between the best and worst-performing shares the environment is changing in favour of the active stockpicker or active asset manager who picks correctly, creating scope to outperform the market.

The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.

Risk considerations

The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

Investments concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions, may be subject to higher volatility resulting in large changes in value, which may cause an adverse impact.

Equity prices fluctuate daily, based on many factors including general, economic, industry or company news.

1. The period of time in which an economy moves from a state of expansion to one of contraction, before expanding again is known as the economic, or “business cycle”.

2. The rating of a sector or an area of a stock market is a measure of how highly, or lowly, investors value it. It can be expressed by a variety of valuation metrics, such as the price-to-earnings (P/E) ratio. The P/E of a sector/area is its current level divided by its expected aggregate future earnings – when the P/E falls, the sector/area is said to have suffered a de-rating.