The Outlook: October 2020 Economic commentary
UK equities: time to play catch-up?
It’s never nice to feel unloved and undervalued. Unfortunately, this is a label that increasingly characterises the UK equity market. Against the backdrop of Brexit-related uncertainty, the UK market has been out of favour with investors in recent years and the fallout from the coronavirus pandemic has only made matters worse. While global equity markets, led by the US and China, are now showing gains for the year, the broad UK market is still nursing losses of around 20%.
It might be tempting to put this down to the government’s poor handling of the pandemic and the fact that the UK economy experienced a worse contraction during the first half of the year than its developed market peers.
However, a bigger problem has been the sectoral make-up of the UK market; in particular a lack of exposure to fast-growing tech companies and an above-average weighting to underperforming sectors such as banks and oil. With the coronavirus pandemic accelerating the shift towards ‘online living’, the big tech ‘mega caps’ such as Facebook, Amazon, Alphabet and Netflix which dominate the US equity market, have led markets higher this year.
The UK has no such global counterparts; more generally, the tech sector makes up less than 2% of the overall UK market, a fraction of the global average weighting of over 20%. The relatively high representation of energy companies within the UK – accounting for 8.5% of the market versus 2.8% globally – has also hurt performance.
Prior to the virus, the big oil and gas companies were already under pressure from a trend for investors to divest of fossil fuel stocks. The reduction in travel resulting from the pandemic and ensuing weakness in the oil price has compounded the industry’s woes, with the global sector down more than 40% since the start of the year.
Similarly, the poor performance of global banks – down about 30% year to date – has hampered UK equities, where financials have a weighting of around 17% compared with a global average of around 12%. The global banking sector’s fortunes have been soured by rock-bottom interest rates, which make lending activities less profitable, and the prospect of losses on loan books resulting from the global coronavirus recession.
In addition, UK lenders have been hit by recent speculation that the Bank of England (BoE) could at some stage cut interest rates into negative territory – a move that would effectively act as a tax on the banking sector and weigh on profitability. Shares in UK banks have nearly halved in value since the start of 2020.
Indeed, the pattern of UK companies underperforming their global counterparts can be seen across most sectors. For example, the share prices of global miners are up nearly 10% since the start of the year, while those in the UK are down around 5%. It is a similar story in the industrials sector.
The upshot of an extended period of underperformance is that UK equities are now attractively priced relative to the rest of the world. According to JP Morgan, the UK market currently trades at its lowest forward price/earnings (or P/E, a measure of valuation which compares the price of a company or market against expected profits) level versus its global peers in the last two decades.
Moreover, this measure of relative valuation is still at 20-year lows if the troubled banking and energy sectors are excluded. Such a large gap provides clear potential for the UK to outperform global equities going forward. Indeed, JP Morgan note that the last time that UK equities were this ‘cheap’ versus world equities – in July 2003 and April 2009 – they outperformed the global benchmark during the following 12 months.
Such extreme relative valuations are a reflection of just how unpopular UK equities have become. UK equity funds have seen heavy outflows in recent months, and survey data shows that global fund managers consistently cite the UK as their top ‘underweight’ region.
The question going forward is what might cause investors to take a more positive view of the UK market?
Clearly, Brexit has been a major source of angst for investors in recent years, and clarity regarding the future trading relationship between the EU and the UK would remove a degree of uncertainty. Failure to secure a trade deal might be expected to put renewed downward pressure on sterling. A weaker pound would boost the foreign earnings of UK-listed companies and would probably see large-cap stocks, where overseas sales make up over 70% of revenues, outperform the more domestically focused mid-caps.
Conversely, the agreement of even a ‘narrow’ trade deal could see the pound strengthen, which in itself would be a headwind to overseas earners. This said, given attractive relative valuations and the current extreme negative positioning towards UK equities, the improved sentiment that would accompany a trade deal could potentially usher in a simultaneous move up in both the pound and the broad UK equity market. The avoidance of a ‘no-deal’ Brexit would reduce the likelihood of the BoE taking interest rates negative, which in turn would take some of the pressure off the banks.
The US election in November could also usher in a global sector rotation which might provide a more favourable backdrop for UK equities. We argued in our commentary of August 2020 that a ‘democratic sweep’, which sees Joe Biden win the presidency and the Democratic Party take control of congress, could lead to higher taxes, a sharp increase in infrastructure spending and a rise in bond yields. Higher public works spending could push up commodity prices and boost mining companies, which have an above-average weighting in the UK market (around 10% versus a global average of 5%). Higher bond yields would threaten the recent market leadership of so-called ‘growth’ companies - most notably the richly-valued big US tech names – whose share prices are most vulnerable to a rise in the rate used to discount future cash flows.
In addition, the possibility of higher corporate tax rates and increased regulation under a democrat administration might dull the appeal of US equities. The big US tech companies also face the prospect of tougher regulatory standards from the European Union.
Of course, the approval and swift roll-out of a coronavirus vaccine should be positive for investor risk sentiment in general, while also carrying the potential to narrow the performance shortfall between UK and global equities.
The pandemic will no doubt make lasting changes to the world of work, commerce and entertainment. However, a vaccine that facilitates a return towards pre-covid levels of mobility should be a tailwind for the travel/leisure industry, the oil majors and the banks. By the same token, a vaccine could also take the shine off the so-called ‘stay at home’ stocks (online retail/entertainment, tech etc.) which are underrepresented on the UK market.
Further evidence that dividends are being restored would also be a positive for the UK market. Deep cuts to dividends earlier this year have taken a heavy toll on a market whose income-generating qualities have been a key attraction. Estimates suggest that company pay-outs could fall by around 40% in 2020. However, the mood music has started to sound more upbeat of late, with a steady stream of companies announcing that dividend payments will resume again.
Indeed, despite the steep decline in pay-outs, the UK market still carries a dividend yield of nearly 4%. This looks attractive when compared with near-zero rates on government bonds and the 2% average yield on global equities. Moreover, a substantial dividend could prove advantageous if global equity markets enter a period of range-bound trading following the bounce back from the March lows.
In conclusion, although a range of factors has weighed on UK equity market performance in recent years, there are good reasons to think that much of the bad news is now in the price and better times lie ahead. The UK’s ‘unfashionable’ sector composition might mean that it will struggle to generate the excitement associated with ‘whizzy’, tech-heavy markets. However, given the importance of starting valuations and reinvested dividends in driving long-term returns, UK equities still have a valuable role to play in a diversified portfolio.
20th October 2020
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.