UK fundamentals point to upside potential
The UK has been among the fastest-growing developed economies in recent years. Although 2016 got off to a shaky start and Brexit uncertainty may dominate in the near term, there are plenty of good reasons for continued conviction in the UK stock market this year.
The domestic economy continues to recover
The falling unemployment rate highlights the improving economic situation. Wage growth has lagged the recovery, but wages are now—finally—increasing faster than inflation. This doesn’t look set to push up interest rates in the near term, though, as inflationary pressures elsewhere are limited, providing scope for monetary policy to continue to support growth.
Faster wage growth and higher employment should fuel stronger consumer demand—which we expect to be the main driver of growth in the UK this year.
Recession risk remains low
2016 began with heavy falls on equity markets, with one of the big contributing factors being increased worries about a developed market recession after a slowdown in growth at the end of 2015. However, given record employment and the lack of signs of a slowing labour market, the risk of recession in the UK currently looks low.
Industrial production has been weak recently, but it’s not uncommon to see dips in this measure without a recession. Business investment intentions are falling in the manufacturing sector, but remain positive in the much larger service sector. Contractions in manufacturing alone tend not to cause recessions, as the sector accounts for under 15% of GDP (Source: World Bank)
Earnings better behind the headlines
Another contributing factor to the sell-off at the beginning of the year was concern over corporate earnings. At the index level, earnings for UK companies have collapsed. However, excluding energy and mining companies, which were hit hard by the fall in commodity prices, earnings have held up much better.
Beyond the energy and mining sectors, lower commodity prices are good news, both for consumers, who have more money in their pockets as a result of lower fuel costs, and for businesses that use rather than produce natural resources. The high weighting of the FTSE 100 to these sectors also means that the UK stands to benefit more than other markets at the index level from any commodity price rebound.
UK valuations are relatively attractive
UK equities are not expensive on a price-to-earnings (P/E) basis relative to history. And with scope for earnings to recover significantly from their poor performance in recent years, the cyclically adjusted P/E, which takes into account where we are in the earnings cycle, suggests that the market is very cheap relative to its long-term average (see chart).
Meanwhile, UK dividend yields are high relative to government bond yields and to other equity markets, in a world in which income is still hard to come by. As a result, any short-term volatility that arises from the upcoming European Union referendum may represent an attractive entry point in a market backed by a continuing economic recovery and the potential for earnings growth.
Read more about J.P. Morgan Asset Management’s UK equity fund range:
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