A global pandemic with the associated disruption, protracted Brexit negotiations and a dividend drought has led to relatively weak returns from UK shares over the past year or so, but in recent months, prospects have brightened, and markets have responded. We asked Dan Hanbury, manager of the R&M UK Equity Smaller Companies and UK Equity Income funds, for his latest views.
Why have we seen the UK market improve recently?
Several factors have brought about the rally in UK equities after several moribund months following last March’s global sell off. The most prominent of these are of course the fiscal and monetary stimulus delivered as well as the announcement on 9th November 2020, colloquially becoming known as Pfizer Monday, of the production of a successful Covid-19 vaccine. At this point, markets seemed to turn almost on a sixpence, with expectations of global growth rising as investors saw a positive way out of the crisis.
For the UK in particular, other factors have also been in play: the end of Brexit negotiations, expectations of government support for infrastructure and the green economy, and the prospect of consumers spending their enforced savings. We also need to look at the market itself. For years UK equities have been unloved and priced relatively cheaply both to their history and globally. This has been despite the market being full of attractive and diverse investment opportunities. Last, but most certainly not least, is the excellent progress the UK has made with the vaccine rollout, pointing to a strong recovery over the next 18 months or so, relative to many other developed economies.
Are these structural drivers, can they be sustained?
Most of these are cyclical drivers and so their sustainability is somewhat constrained and difficult to predict, particularly at this moment, as we are in uncharted territory with a global pandemic.
The return to inflation could be said to be a structural driver, but only if we feel it is a permanent factor and not a transient one, and it is currently debatable whether it will feed through meaningfully to wages more broadly. The same goes for the changes in interest rates and bond yields, currently supporting sectors such as banks and resources companies. We would always maintain a diversified portfolio rather than tip portfolios to bet on a single macro-economic outcome anyhow.
One driver that we believe is structural and sustainable is the green economy and de-carbonisation. Not only is this the ‘right thing’ to do and a major, permanent part of capital allocation decisions, but it has central government and increasingly consumer support. The key with this is to understand where real sustainable investments are, and for allocators to ensure that they are careful not to chase growth stocks which have built their ESG credentials and now trade on excessive valuations.
What risks lie on the horizon?
As always there are numerous risks that lie ahead, and it is debatable which of these are greater or more likely to become a reality.
- We have mentioned inflation risk, and whether it be structural or transient, but there is certainly concern at the prospect of food and commodity inflation leading to further inequality, very probably in areas sadly hardest hit by the pandemic. There is equally the risk that wage inflation disappoints, inflation is indeed transient and aggregate demand remains moribund in the medium to long term
- With animal spirits currently riding high, confidence being knocked, perhaps with further outbreaks or new strains of Covid or more likely perceived changes to government and central bank support, could have an adverse impact on equities
- Geopolitical risk is ever present with conflict in the Middle East, China flexing its muscles in Taiwan, and Russia and the Ukraine tensions high
- Finally, there is little doubt that the pandemic will be with us for some time, but we don’t know exactly how or for how long, it will continue to impact our lives. Whilst the recovery looks positive in the UK, we don’t yet understand how the ‘new normal’ will look and which sectors and companies are priced correctly to benefit or lose out over the longer term.
What are the best opportunities for maximising returns and growing dividends?
As stock pickers we systematically screen for different stocks and sectors in the market where we believe there is the greatest potential for money making investments. With smaller companies, there is less sell side research available and fewer people analysing the stocks and so we often find the greatest alpha opportunities.
It’s also possible to hunt down attractive, unloved companies that are more than just cyclical survivors of the economic downturn. Cyclicals are a year into their recovery as they bottomed out in March last year, so it is key to invest in companies which have perhaps something of a structural tailwind too. For example, a cyclical industrial stock that has products in a developed market which will benefit from legislative drivers within the green economy.
In terms of growing dividends, it’s been a difficult 5 to 10 years for income investors and last year was a particularly bad one, as we saw so many of the big firms cutting or deferring their dividends. Reports show that dividends are down about 40 percent in the UK over one year. The encouraging news is that the re-basing process sets up a bottom, and we are likely to see some better news with many companies set to reinstate and hopefully provide positive guidance. UK investors can pick attractive domestic as well as international stocks, which will start to grow both their earnings and dividends again.
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