Global fund manager sentiment indicates pessimism around UK equities is at an all-time high. However, market holds compelling value for income investors.
While we have witnessed a recent surge in FTSE stocks due to fresh falls in sterling, UK market companies have been stubbornly out-of-favour with global investors. Political uncertainty continues to linger, and investors are concerned about how potential interest rate hikes this year could affect the economy.
As global asset allocators have taken a consensus underweight position to the FTSE, the UK is at its most unloved point in decades relative to other developed markets. However, for the contrarian investor, macroeconomic overhangs often signal a potential buying opportunity. Given current market dynamics, my conviction is that the UK is in a startlingly good place and offers tremendous relative value for long-term income investors.
Yes, there are challenges. Brexit uncertainty will continue to cloud the economic picture and the threat of a left-wing government coming into power with a mandate to hike taxes and nationalise large parts of the economy is concerning. However, as long-term investors, you learn to live with macro-headwinds which tend to come and go. Delving deeper into the market fundamentals, the case for UK equities becomes clear.
Firstly, the UK market is buoyed by a greatly depreciated pound. A weaker pound benefits FTSE 100 constituents, where 75 per cent of earnings are derived from overseas currencies. This has been a tailwind for recent FTSE 100 strength and will continue to power the performance across an index with a multi-national profile.
While a weakening US dollar may act as a headwind, the devaluation of the pound has left the UK equity market looking cheap compared to its global peers and created the most attractive relative valuation dynamic in decades.
Relative value play
Indeed, despite recent market gains, the FTSE has still dramatically lagged some of its developed market counterparts since the 2008 financial crisis. For example, since the beginning of 2018, the MSCI North America index has delivered a 223 per cent return, while the FTSE All-share and FTSE 100 indices have relatively underperformed, delivering respective returns of 92.3 and 81.5 per cent.
Moreover, the UK has a P/E ratio of 15.2 and is yielding 3.1 per cent. In contrast, the S&P 500 is currently displaying a P/E of 20.8 and a dividend yield of just 1.9 per cent. Thus, not only is the market attractive from a valuation perspective, but it is also a source of strong dividends when rates remain at a low level.
An incremental rise in rates, which is expected, should not overly hurt the stock market, but steep hikes could spark a sharp sell-off – a scenario that can’t be discounted if you are a student of history.
When there is a disparity in growth between the major developed market regions, you have a safety valve against inflation. However, when there is synchronised growth across all advanced economies, inflation is unleashed – and, as we saw both in the 2005/2006 and 1999/2000 periods, analysts dramatically underestimated the speed of the rate cycle. In this environment, we believe being defensively low beta will help insulate investors from any market disruption, while also providing a steady stream of dividends.
Return of value
History also tells us a rising rate environment does not tend to be good for asset prices – and rates have a corrosive effect on the profitability of growth stocks. More sensitive to changes in long-term rates, the future cash flows of growth stocks are discounted at a higher rate, leading to eventual de-ratings. Conversely, less sensitive to rising rates, value stocks tend to be re-rated and come into their own.
Indeed, some value stocks are actively supported by a rising rate environment. For example, financials, such as insurance and banks, benefit from inflation – particularly when wage growth picks up. For the banking sector, the rate hiking cycle can have a powerful effect. They profit from an increase in their core lending margin – and this additional interest goes straight to earnings. We have subsequently increased our exposure in these sectors over the last six months.
Fixed income: Reward free risk?
While rates can put a number of asset classes under duress, it can be particularly value-destructive for fixed income. In 2007, we had a 70 per cent allocation to fixed interest, when we could pick triple-B corporate bonds yielding 9 per cent. Since then, rates, and subsequently yields, have fallen dramatically. We have reduced our fixed interest exposure consequently, and now have the lowest bond exposure in the history of the portfolio.
With equities yielding such a premium over bonds and value set to come back into vogue, the UK has plenty of opportunities for investors. Moreover, set against the global backdrop, currency and relative valuation dynamics make the UK an enticing contrarian call.
Robin Hepworth, portfolio manager of the EdenTree Higher Income Fund.