What is the outlook for UK equities in 2017?
By James Yardley, FundCalibre, Russ Mould, AJ Bell, James Illsey, JPM UK Equity Core fund and Mark Burgess, Columbia Threadneedle.
James Yardley, senior fund researcher at FundCalibre
This year has been a tough one for active managers. It was the first time since 2011 that mid-caps underperformed large-caps by a significant amount. Value stocks such as miners and oil companies had a particularly strong year, while the market finally fell out of love with the safer “bond proxies”.
Financials has been the one value sector left behind in 2016. If interest rate expectations keep rising, we expect it to be the next sector to rally. Pharma stocks did very well post-Brexit, following the fall in the pound but have since given up all of their gains. These stocks are now starting to look attractive too.
UK mid-caps also look better value and most of the sell-off this year has been down to a de-rating rather than any major profit warnings (with a few notable exceptions). We would expect some of the domestic mid-cap stocks to stage a recovery, as long as the economy does not hit major difficulties.
Overall, the UK market looks slightly expensive. There are some stocks that do look good value but a lot will depend on the wider economy and the upcoming Brexit process. Given the uncertainty we are minded to be cautious.
Russ Mould, investment director at AJ Bell
The terms of Brexit will be instrumental in shaping sentiment towards the UK equity market. A hard Brexit could well snuff out the autumn rally in sterling, especially as Britain runs a combined annual budget and trade deficit that would shame a banana republic.
That in turn could boost overseas earners. However, this trade is now well-known and, ironically, the real value may be appearing in downtrodden domestic names, such as real estate and consumer discretionary stocks, where a lot of the potential damage of a hard Brexit is priced in.
This could offer further scope to funds known for their value-hunting expertise, especially if Brexit does not turn out to be as bad as feared.
The UK’s 4 per cent-plus dividend yield for 2017 could also be a source of support, particularly as rising oil prices underpin the 24 per cent contribution to UK dividend payments forecast to come from Shell and BP alone.
Meanwhile, with banks representing 14 per cent of the FTSE 100’s market cap and 15 per cent of both profits and dividend payments in 2015, this is one sector fund managers have to get right if they are to outperform.
The rally late this year has caught many off guard and if that momentum continues it could force many to clamber aboard, giving the FTSE a lift. That said, if the UK economy fails to deliver and bond yields go lower again, banks could once again find themselves out in the cold.
James Illsley, manager of the JPM UK Equity Core fund
The devaluation in sterling has been beneficial to UK large caps, which derive around 80 per cent of their sales from overseas. Companies with significant international earnings will do well as this continues into 2017. A 15 per cent fall in the currency equates to an almost 11 per cent tailwind for UK mega-caps. For dividends, the weak pound is set to provide an exchange rate boost of £4.3bn in 2016 alone.
What is more, the weakness in sterling has meant UK companies are 15 per cent cheaper for overseas-based acquirers. With funding costs still low but rising as bond rates pick up, we expect M&A to continue as buyers seize this opportunity.
Since the UK referendum and US election there has been a shift in focus towards more fiscal instead of monetary stimulus. This will support economic growth and the return of inflation. Interest rates should move up.
Reflecting that global reflation trade, in UK equities we are seeing a rotation towards value, financials and cyclicals outperforming. As bond yields rise, classic defensive equity sectors and bond proxies have become less attractive. We expect that to continue.
The outlook for housebuilders is also positive and the sector remains attractively valued. The UK housing market continues to receive government support but is massively undersupplied. Demographics are driving new formation of around 250,000 homes per year, against new build rates currently running at about 190,000 units. These trends should benefit names such as Bellway, one of the smaller quoted housebuilders.
Mark Burgess, chief investment officer, EMEA, and global head of equities at Columbia Threadneedle Investments
Arguably, Brexit is just a symptom of excessive global debt and the inequalities that have only widened in a quantitative easing world. Now the UK needs to embrace free trade outside the European Union.
Since the referendum, UK GDP and other data has been positively surprising. Although this could simply be because the event itself has not actually happened yet, it has been argued Brexit will help the UK to rebalance and reduce its reliance on the property market.
In 2016, the UK would have had one of the best rates of economic growth among the G7 (though with expectations of earnings at 1 per cent in 2017 the outlook will be more challenging). Nevertheless, factoring in the collapse in sterling has helped with the current account deficit. It has also helped the UK appear relatively attractive, though the full benefits of this are yet to be felt. Perhaps this could attract foreign investment back into a country from which some have fled?
With the additional implications of President Trump’s plans, sectors such as mining seem less attractive. But despite this and the uncertainty over how Brexit will come to pass, there is still a cautiously optimistic case for UK equities. There are certainly plenty of opportunities for the skilled active manager to find quality investments.