UK equities: Opportunity in the uncertainty
With Article 50 due to be triggered at the end of the quarter, heralding the beginning of the UK’s exit from the EU, the next two years hold more uncertainty than usual for investors in UK equities. Callum Abbot, fund manager, explains why he believes the market continues to offer attractive opportunities for dispassionate stockpickers.
The economy is not the market
The next two years, from a macro and political perspective, are expected to be volatile and uncertain. However, we are quietly confident that UK equities will remain an attractive investment, for three reasons.
First, the UK equity market is not a simple reflection of the UK economy. It is truly global, with around 70% of the FTSE All-Share’s earnings coming from overseas1. In fact, the proportion of earnings companies in the index sourced from emerging markets or from the US is very similar to the proportion they source from the UK. As a result, the UK equity market could offer an effective way to invest in the robust global economy through industry-leading companies. Further, any sterling weakness can increase the value of overseas earnings for UK investors, making sterling a natural shock absorber to the EU negotiations. Equally, if negotiations go smoothly, then a robust domestic economy will be a bonus for the equity market, as domestic stocks will be well supported.
Second, analysts are forecasting 15% earnings growth next year and 10% the year after. A key driver is the rebound in commodities, driven by improving global growth and Chinese stimulus. The UK equity market has a near 20% exposure to this recovery2.
Finally, valuation remains compelling compared to other regions and other asset classes. The FTSE All-Share’s dividend yield stands at 4.1%, compared to 2.1% for the US, while UK Gilts are yielding 1.5%3.
Reflation is good news for lenders
Given this backdrop there are several investment themes playing out in our stock selection.
Reflation is one of these. Equities offer a natural inflation hedge, with rising prices boosting overall sales. Certain stocks tend to benefit more than others in this type of environment—in particular, value and cyclical names, which are looking attractive.
More specifically, banks tend to be primary beneficiaries of reflation. As rates rise, the gap widens between what lenders charge for loans and what they pay for deposits, increasing profitability. Given the low starting point of rates and the lowly valuation of banks, this theme arguably has considerable room to run.
So-called growth and defensive stocks tend to underperform when rates rise. Utilities and pharmaceuticals are good examples of this: the former are bond proxies, meaning they perform less well when bonds underperform; the latter face the additional burden of overt criticism about drug pricing from US politicians.
Opportunity and risk at the stock level
Opportunities and risks are not just about themes and sectors, but also exist at the stock level. Using the general retail sector as an example, retailers that have high import costs and large store estates will likely lose out to online fast fashion retailers in the current environment.
While political events will inevitably create volatility in the next two years, they will also likely create numerous opportunities for those stockpickers that can react to new information both swiftly and dispassionately. Our behavioural finance approach to stock picking takes evidence-based views, which avoid emotional decision-making, meaning we are well-placed to benefit from what will undoubtedly be an emotionally charged period.
Callum Abbot is fund manager of the JPM UK Equity Plus Fund. Read more about the fund: UK Advisers
1.Source: Factset as of 31 December 2016
2.Source: Factset as of 31 January 2017
3.Source: JPM Guide To The Markets Q1 2017, slides 43 and 45. Slide 43 UK and US equity yields - J.P. Morgan Economic Research, J.P. Morgan Asset Management. UK is MSCI UK, US is S&P 500. Slide 45 UK 10 year Gilt - FactSet, FTSE, J.P. Morgan Asset Management
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