Talking Point: Where next for UK equities?

What is there to love about the UK market?

The UK is currently a friendless market — unloved, underperforming and facing a perfect storm of headwinds that instil little confidence to cautious consumers.

Uncertainty over Brexit, the country’s arguably poor handling of the coronavirus crisis, the subsequent dividend drought and the UK’s exposure to unpopular sectors have left the region with an uphill struggle.

Data from the Investment Association shows investors have felt the pinch and voted with their feet. More than £1.5bn was pulled from funds in UK sectors from May to July, in the same months that £2.5bn was plunged into global funds.

Tom Becket, chief investment officer at Psigma, says: “It’s basically a perfect storm for UK equities.

“The UK’s significant sectors are under pressure, we don’t have much exposure to the sectors doing well. And then combine all that with the Brexit situation and the fact there is not a huge confidence in the domestic political and Covid-19 situation.”

And the UK has lagged other markets, particularly in the aftermath of the coronavirus-induced market crashes.

Some major markets — such as the S&P 500, the Nikkei 225 and China’s SSE Composite Index — are up year-to-date, with the US blue chip index climbing 56 per cent since March.

Meanwhile, the UK has struggled to recoup its initial pandemic losses. The FTSE 100 is down 22 per cent since the start of 2020, having only recovered 18 per cent since global markets tumbled mid-March.

Jason Broomer, investment director at Square Mile, says the UK was in an “unfortunate place” at the moment and with a number of factors “not going in it’s favour”.

He adds: “The UK is an unloved market. It has clearly been hit worse by the economic side of the pandemic and the GDP shrinkage is forecast to be the worst out of the major countries.”

Shortcoming sectors

The UK’s struggles can be understood by the sectors which underpin its market and economy.

Its service-driven economy has suffered as national lockdowns curbed domestic and international travel while curfews and social distancing rules have hamstrung the hospitality sector.

Financials and oil companies, both prevalent in the FTSE 100, are economically sensitive stocks, while the UK’s fame as a ‘dividend haven’ has been bruised amid the crisis.

Charlie Parker, managing director of Albemarle Street Partners, says the UK was home to “big victims of the virus”.

He says: “Retail, hospitality and in-person service sectors are in dire straits. In this context, anything staple is going to fare better than anything discretionary.”

Adrian Lowcock, head of personal investing at Willis Owen, agrees, pointing out that airlines, hotels, cinemas, restaurants and pubs had seen the “majority of their business dry up for much of 2020”.  

He adds: “The oil and gas industry has also suffered as the oil price collapsed and demand has shrivelled up and dividends were slashed.”

The price of oil has been on a decline since the start of the year, tumbling 36 per cent since January 1 and hurting big UK oil stocks such as BP and Shell.

At the end of March, the price of oil hit an 18-year low when Brent Crude Oil — the international benchmark oil price — fell to $21.76 (£17.68), the lowest since 2002.

On top of this, the UK’s attractiveness as a ‘dividend haven’ wilted when companies began slashing their payouts amid the crisis, with about 40 per cent of dividends scrapped.

For the UK market, major blows came when the biggest banks and insurers ditched their payments for the rest of the year following pressure from the Bank of England to maintain a cash buffer to help them through the coronavirus crisis.

But it was not all doom and gloom, with some managers positive about the future of certain UK sectors.

Jean Roche, co-manager of the Schroder UK Mid Cap Fund, says: “The consumer has led the way in the recovery, and therefore the outlook for responsive and forward-looking consumer facing companies operating in niches which are performing well, is bright. 

“In sectors such as leisure, capacity exiting the market will mean that the survivors are in a very strong position, though this may take some time to play out.”

For Will Hobbs, chief investment officer at Barclays Wealth and Investments, the UK economy faces its challenges in a “far better position than was feared only a few months ago”.

He adds: “This pandemic has ushered the world a few further steps into the so-called fourth industrial revolution.

“How effectively we disseminate, and adapt to, the productive marvels that will perhaps emerge from this next revolution will obviously have a major bearing on the outlook for the years ahead.”

The epitome of a value play

Experts were generally optimistic about the future of investing in the UK, primarily arguing that its stocks were undervalued and could therefore offer good returns following any global economic recovery.

Simon Evan-Cook, fund manager at Premier Miton, says: “Yes, on a ‘macro’ basis the picture looks cloudy at best, with the pandemic an area of concern, mixed in with the other great unknown of Brexit. 

“But these are well-known factors, and are the reason that UK equities are good value today. 

“Anything less than an unexpected disaster on either front and we think there’s a decent chance the market will react well.”

Ben Yearsley, investment consultant at Fairview Investing, agrees, adding that the market would “fly” against a backdrop of a Covid-19 vaccine and a Brexit deal.

He says: “The UK is cheap on most measures, partly down to Covid and partly down to Brexit. And sterling is cheap too.”

Mr Becket describes the UK as the “epitome of a value play”. 

As value funds and shares – which put more of an emphasis on the price paid for a stock rather than the near-term earnings growth prospects of a company – typically perform better when inflation and interest rates are rising and economic growth is strong, the strategy has been out of favour for more than a decade.

But buying companies currently “unloved” at low share prices mean the returns can be much greater when, or if, the tides turn.

Mr Becket says: “The UK could well be the best way to play the global re-opening. All the key components to make it an obvious contrarian opportunity are in place.”

Mr Parker agrees, saying the cheapness of the UK market meant he had an expected annual return of 7 per cent on the UK over the next five years compared to 4.4 per cent for the United States. He adds: “However, this opportunity will require delicate timing.”

Where to look

Getting access to the UK economy is not as simple as buying a FTSE tracker, experts were quick to point out.

Mr Hobbs says: “The large-cap equity sector dances mainly to the tune of factors outside of this economy. The smaller in size you go, the more of the footprint of the UK economy you are likely to find.”

FTSE 100 companies derive approximately two-thirds, or around 70 per cent, of revenues from overseas, while the FTSE 250 has more of a 50/50 split.

The outcome of Brexit trade negotiations is set to play a key part in how different sized companies perform in the coming years, as the pound’s movements impact the indices in opposite ways.

Mr Parker says: “A successful resolution would boost sterling and support medium-sized companies [...] while large-caps could be hampered by a sterling recovery.

“In this context we are sticking to quality and growth exposure in the UK and holding only modest positions in UK value.”

There are other reasons to gain exposure to the small and mid-cap parts of the UK economy, with an accelerating mergers and acquisitions trend set to boost SME returns.

In fact, research indicates that on average, almost 6 per cent of companies in the UK’s SME indices are acquired each year. 

Mr Roche says: “This is one of the reasons these indices outperform larger company indices over time. So it could be beneficial for investors to have some exposure to these indices.”

Mr Becket agrees, adding: “We know the world is sitting on a huge amount of money both in the form of asset managers and on the venture capital side so the UK could benefit from significant trends in M&A.”

In terms of active versus passive, it is often argued that investors gain more from active management in less efficient and less prosperous markets — such as the UK’s current position.

The UK’s value-heavy bias means indices are unlikely to outperform until there is a revival of value stocks, but active managers are (sometimes) able to pick the winners from the losers.

Mr Evan-Cook says: “Within the market, there are plenty of value and growth stocks for active fund managers to choose from. 

“We think the current conditions, having been driven by both extreme fear and greed, give genuinely active managers a lot of great opportunities to choose from.”

For Mr Lowcock, a trio of funds hit all the right UK spots. He suggested the Man GLG Undervalued Assets fund for offering exposure to any value recovery, claiming that manager Henry Dixon could “move swiftly to exit value traps”.

Columbia Threadneedle’s UK Equity Income was a “core holding” for exposure to UK dividends, Mr Lowcock said, while Dan Nichols’ Merian UK Smaller Companies provided access to growth companies in the UK small-cap space.

Mr Yearsley promoted the Montanaro UK Smaller Companies trust. He said: “I still like buying small and mid caps as they tend to be less of a value trap, have more growth prospects and are still cheap. 

“So something like Montanaro UK smaller companies trust is ideal.”

But Mr Hobbs suggested casting an investment net “a little wider” than the recent winning sectors and asset classes to plan for a “relatively unpredictable” future.

He said: “It would hardly be a stretch to imagine the decade ahead looking quite different from the decade just gone for example. 

“To that end, the types of investments – styles, regions, sectors – that you need to bring to bear in the decade ahead may also look quite different, to plan for a future that isn’t just a continuation of the recent past.”

imogen.tew@ft.com