The case for UK equities
- The UK economy has seen a strong rebound since the lows of the pandemic
- The stock market has also moved forward as market leadership has changed
- Companies are in good shape, with dividends and earnings coming back strongly
The UK is bouncing back. Economic growth is accelerating and the stock market has surged since the start of the year. It is a marked contrast from the pattern of the last few years, when the UK was laid low by Brexit and then by a confused response to the pandemic. Can this economic strength endure and will it translate into continued strong returns for investors?
Sree Kochugovidan, Senior Economist at Aberdeen Standard Investments, says that while the global economy is set for a sharp rebound and above trend growth, there is significant divergence across countries in the timing, speed and strength of that recovery. The UK is emerging as one of the stronger economies, thanks largely to the fast pace of its vaccine programme and swifter reopening schedule.
She says: “At the moment, we expect strong momentum for UK growth as we enter this new phase of reopening. In addition, we’ve seen that the UK economy has been quite resilient in the recent lockdown, consumers and businesses have reacted well to the latest set of restrictions. Growth numbers haven’t been as severely affected. At the same time, the labour market has been well-protected by furlough schemes.”
That said, Sree expects to see a rotation in terms of the different sectors and the type of spending. Retail spending has led to date, but there is likely to be a shift from household spending on durable goods towards leisure, services and hospitality as the economy reopens.
This has been seen in stronger UK stock market performance since the start of the year. Partly, this is a result of the dissipation of key risks such as Brexit and Covid. However, it is also because many of the more ‘old economy’ or ‘value’ type companies that dominate the UK market had become extremely cheap and the successful vaccines roll-out prompted a reappraisal of those sectors and a rotation in markets.
There has also been a significant improvement in the earnings and dividend outlook for many of these companies. Thomas Moore, manager of Aberdeen Standard Equity Income Trust, says: “We’re seeing quite a dramatic increase in earnings and dividends across a range of sectors. This is coming from good strong fundamentals – companies with robust governance are often survivors in their sectors, they are well-run with good long-term drivers. They’re coming from a low base in terms of earnings and dividends and we’re looking at some quite spectacular increases.”
This includes sectors such as mining, where Thomas points to a 90%+ increase in dividends this year. He has seen similar increases in sectors such as industrials, construction, housebuilding, consumer discretionary and the financial sector.
Following this strong performance, can the UK continue to do well? Ken Wotton, manager of the Strategic Equity Capital Trust, believes that there are a number of elements in the UK market’s favour: “In spite of the outperformance of the last few months, the UK is still trading on a material discount to other developed markets, particularly the US. UK small caps, where we invest, are on multi-year discounts. Those discounts are starting to drive flows back into smaller companies.”
He also sees takeover activity driving the market as private equity buyers with deep pockets look for undervalued assets. Strategic Equity Capital is a 20-stock portfolio and has seen three takeover offers in the last three or four months. “Healthcare in particular has seen a number of private equity bids in UK small and mid cap equities. We are seeing elevated deal flow and a hot IPO market.”
That said, Ken believes the environment remains difficult to forecast, given heightened uncertainty. This may create volatility, as the trajectory of earnings recovery will be stock and sector-specific: “It should be a good environment for stockpickers that are focused on the longer-term.”
Georgina Cooper, manager of Dunedin Income Growth Investment Trust agrees that investors will need to pick with caution. In some cases, the market has got ahead of itself, reflecting increased earnings in the share price before they have been completely realised. Nevertheless, she believes that in many areas there is still scope for upgrades to forecasts: “Management teams have generally been conservative with their expectations because of the continued uncertainty, particularly for operationally levered companies. The UK market still looks cheap and we are more advanced in economic recovery. In our view, the market can keep ticking up and the opportunity to close that valuation gap is still there.”
Plus, he says, positive trading updates are coming in “thick and fast” from companies. “It’s easy, after the last 10 years, to lure yourself into a doomsday view but that is not what we’re seeing.”
The fear, for both Georgina and Sree, is higher inflation. Georgina says some companies are starting to see cost inflation, and Sree says it is a risk she is keeping a close eye on. Nevertheless, she believes the current pressures will be transitory.
Although the UK economy tends to be associated with ‘old economy’ sectors such as banking, mining or oil and gas, Thomas says it is more dynamic than it appears. Capital tends to flow to new and productive areas of the economy. Increasingly, those structural trends accelerated by the pandemic, such as ecommerce, digital transformation, sustainability or healthcare innovation, are reflected in the UK market. Ken says that there are a host of new businesses coming to market for fund managers to consider.
The UK has seen a good run, but with valuations low, some key risks diminishing and corporate prospects improving, there should be more to come from UK companies. That said, there may be a rotation in stock market leadership and greater volatility. Careful stock picking should help avoid the pitfalls.
Risk factors you should consider prior to investing:
- The value of investments and the income from them can fall and investors may get back less than the amount invested.
- Past performance is not a guide to future results.
- Investment in the companies may not be appropriate for investors who plan to withdraw their money within 5 years.
Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.
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