UK equities – why the recovery story could be underway

Covid disruption, protracted Brexit negotiations and a dividend drought led to weak returns from UK shares in 2020, but is the tide turning?

| 7 min read

Since the EU referendum in 2016, investors have been more wary of UK shares. For some the political uncertainty was too great and there were plenty of appealing opportunities elsewhere. Skewed towards out-of-favour areas such as energy, commodities and banks, it was an easy decision to dial back UK exposure. A depreciating currency and a lack of direct exposure to the all-important green and digital revolutions only added to the weak sentiment.

But could the attributes of the UK market be about to become a tailwind rather than a headwind? There are several reasons why the market could make a comeback in 2021.

Brexit uncertainty receding

Brexit uncertainty led to a ‘buyers’ strike’ but the Christmas Eve announcement of a UK-EU trade deal promised an end to four and a half years of uncertainty and speculation. While there are areas of the relationship still to be finalised, and there are some disruptions to the flow of goods, it has brought some much-needed clarity to many UK businesses and we have been spared a more disruptive ‘no deal’ scenario.

There is a further political tailwind from the US. The decisive US election result in favour of Democrat Joe Biden has helped more economically sensitive segments of the market to recover as he is expected to unleash Covid recovery and infrastructure spending that could mean greater earnings for industrial companies, builders and suppliers of vital metals and commodities.

This has reinforced a switch into these areas that started following the positive news on Covid vaccines in November, which gave investors greater confidence of rapid economic recovery. The UK market has lots of exposure to energy and mining, so it has already benefitted to a degree.

It is also possible that the Achilles heel of the UK market – lack of technology exposure – might at some point be of some relative benefit. The President elect may be tougher on the US tech giants, which make up such a significant percentage of global market indices, both in terms of taxes as well as privacy and data rules.

A (possible!) value rotation

After a period in which a relatively narrow band of perceived ‘winning’ businesses have driven market returns, we don’t know for sure whether the expansion in market leadership and a shift towards value investing is another false dawn like 2016 or the start of a regime change. Yet with an economic recovery looking more likely in 2021, it is possible that some investors need to consider increasing their exposure to value stocks – and in doing so the UK will likely come onto their radar.

There have been two previous occasions went this kind of rotation has occurred. In 2000 investors became convinced that the future was in technology, media and telecommunication stocks and nearly everything outside these sectors became very cheap, thus creating an attractive starting valuation in so called ‘old economy stocks’ that provided strong future returns. Many ‘boring’ sectors such as tobacco and utilities did remarkably well. Then, in 2008/9, the world’s financial system was under threat of collapse, causing panic selling of anything remotely economically sensitive, again setting up a decent period for returns in the cheapest areas.

On these occasions a contrarian mindset and a determination to look at the facts was required rather than to listen to a relentless narrative created by market commentators. Interestingly, the dispersion in valuations is wider now than it was in 2000 and 2009.

Improving dividend picture

What might entice investors back into UK stocks, and cheaper areas generally? One catalyst could be dividends, which may see a concerted rebound.

Historically, UK investors have found their home market attractive for income. However, the disruption from Covid-19 has been savage. FTSE All Share dividends are thought to have fallen by 36% in 2020, with only investors in Australia, where dividends were down by 48%, counting a higher cost. Globally, up until the end of September, Janus Henderson reported that dividends fell by $55 billion, or 14.3%.

At a company and a sector level it is a disparate picture, but overall, we expect a dividend yield of around 3-4% from UK equities in 2021, and view this as a sustainable base for dividend growth. In a world of historically low interest rates it seems an attractive starting point.

Exposure to UK equities

One simple and usually low-cost way to invest is through ‘passive’ investments or ‘trackers’. These aim to replicate the performance of a market rather than beat it as an ‘active’ fund would. They do this by owning all or most of the companies that make up that market’s index.

The primary consideration when selecting a tracker is cost. Using funds with the lowest charging structures can, over the long term especially, translate to higher returns. One option is Fidelity Index UK, which has highly competitive charges, while those preferring a stock market listed alternative that can be traded at any point during market hours could consider an Exchange Traded Fund (ETF) such as iShares Core FTSE 100 UCITS ETF.

For those wishing to focus on the cheaper areas of the market and potentially harness recovering dividends, equity income funds with exposure to economically sensitive stocks and domestic earners could provide greater return potential in a positive economic scenario. One option is JOHCM UK Equity Income whose managers James Lowen and Clive Beagles state that their portfolio is remarkably cheap. They believe that it trades at an even greater discount to the wider market than in January 2009 when measured on a price-to-book basis, which considers that current valuation of a business in relation to its underlying assets. This measure has been a good precursor to better times ahead in the past, but there are of course no guarantees.

2020 saw income pay outs from the fund halve amid the Covid crisis, but the managers’ forecast is for this to rebound by 60%. After a dire period for much of 2020, in the autumn they were finally rewarded for sticking to their investment process. The fund beat the FTSE All Share by 15% in October and November as the cheaper areas of the market awoke. A taster, perhaps, of what is possible as and when more positive news on defeating Covid and economic recovery comes through.

The divergence in performance of UK domestic earners versus international earners since the beginning of 2015 has also been stark as the local economy was ravaged by lockdowns. Tom Moore of Aberdeen Standard Equity Income investment trust has suffered an exceptionally difficult period as a result of this, but is well placed to capture any sustained rotation into UK earners that takes place.

The Trust is nimble and can invest across the spectrum from large to small firms. Notable share price falls in the portfolio from the likes of housebuilder Vistry, Cineworld and National Express have weighed heavily but it has drawn on reserves to keep its dividend growing, and a resumption or increase in pay outs from its underlying investments could be a catalyst for better capital returns.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

UK equities – why the recovery story could be underway

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