Bright spots for careful stockpickers
Equity investors endured a torrid 12 months, culminating in a bruising fourth quarter. A combination of destabilising macro factors dictated sentiment. These included slowing global growth, concerns on the direction of monetary policy, the US/China trade war and the Italian budget crisis. In the UK, Brexit dominated the conversation as fears of a disorderly exit mounted.
Sterling has been weak since the EU referendum in June 2016. However, this has boosted the share price performance of several companies with significant exports and overseas trading interests. A weaker pound makes profits earned in other currencies worth more when translated back to sterling. Mega-cap defensive stocks have also been notable performers as investors sought safe-havens. By contrast, the uncertain political landscape has taken its toll on domestic facing businesses. In many instances, the market sell-off has occurred irrespective of company fundamentals. Taking the FTSE 250 as a proxy, UK domestic stocks have fallen 35% over the last three years.
But despite all these factors, we remain relatively bullish towards UK equities. Here, we examine the reasons informing our view.
An expanding economy[hhmc]
The UK economy continues to expand despite facing numerous headwinds. Unemployment is at a record low, while wages are rising. Contrary to the negative headlines, the UK consumer is in better shape than this time last year. According to the Asda Income Tracker, shoppers have more pounds-in-their-pocket compared to a year ago. However, the contours of that spending are changing. The high street continues to flounder, with HMV the latest casualty. By contrast, some online retailers are flourishing. For example, fast-fashion group Boohoo announced strong revenue results for Q4.
Meanwhile, inflation is likely to drift back towards 2% as the impact of the post-referendum fall in sterling fades. This should give the Bank of England justification for keeping interest rates low. Following the Budget, fiscal policy looks set to become a tailwind to growth. The chancellor has promised a £20.5 billion increase in NHS spending by 2022 and a freeze to fuel duties. He also announced tax cuts on income and business investment.
Strong start for global markets[hhmc]
After a weak conclusion to 2018, global equity markets have made a strong start to 2019. This reflects more attractive valuations and tentative signs of progress in the US/China trade spat. It is possible that President Trump and Premier Xi could strike a deal quicker than expected. Both countries are feeling the effects of tariffs. The disruption is starting to weigh on corporate profits. President Trump may also be keen to secure a victory in light of the prolonged US government shutdown.
With regard to monetary policy, the US Federal Reserve latests statements struck a more dovish tone. Many questioned its decision to raise rates in December, in light of slowing global growth. Pockets of weakness have also emerged in the US economy. Given these factors, we now expect two rather than four rate rises in 2019.
The market sell-off has left many UK businesses unloved. As a result, we see UK equity valuations as attractive relative to their global equivalents. Indeed, valuations are now on a par with the past two recessions. However, we also see a sharp divergence in valuations based on the extent to which investors believe a stock is exposed to macroeconomic turbulence. This is leading to many opportunities in stocks whose valuations do not reflect their strong cash flows and dividends prospects.
Driven by stock-specific analysis, we find these valuation opportunities to be particularly abundant in three areas: domestic rebound, global yield and uncorrelated value.
Potential domestic rebound[hhmc]
As we highlighted, domestic firms have suffered over the last few years. However, this has created numerous opportunities to buy UK businesses with strong market positions and a high return on equity (how much net income they generate in relation to their total amount of shareholder equity) at low valuations. While it is difficult to pinpoint when the macro uncertainty will lift, many companies are growing their cash flows and dividends. We would expect these stocks to re-rate as investors shift their focus back to company fundamentals once the Brexit dust settles. Examples include Close Brothers, the merchant banking group, and Aviva, the multinational insurer.
Global yield opportunities[hhmc]
Global yield companies are those companies with strong overseas earnings and attractive valuations that offer robust cash flows and exposure to fast-growing economies, notably emerging markets.
Many developing countries offer structurally faster growth than developed markets and we think there is a good chance that investors will return to emerging markets in 2019. This is partly because, after a tough 2018, a lot of the bad news for emerging markets is already in the price. As such, any signs of a peak in the US dollar would be a catalyst for emerging markets to return to favour. We have already seen higher inflows into these markets at the start of 2019. This would benefit UK-listed companies in sectors including resources (e.g. Rio Tinto, Anglo American), industrials (e.g. Bodycote) and financials (e.g. Ashmore, HSBC).
It is our firm belief that you do not have to overpay for robust businesses. We have identified a range of stocks that are trading at a discount and whose primary earnings drivers are independent of the domestic UK economic cycle. Examples include infrastructure firm John Laing and insurance group Sabre, both of which continue to deliver strong, noncyclical returns to investors, despite the challenges being faced by the UK economy.
UK equities face numerous challenges, both at home and abroad. Brexit remains the primary concern and markets are likely to be volatile in the short term. However we believe uncertainty is creating stock-level opportunities. Many UK companies are trading at attractive valuations. Domestic-facing companies are primed to recover. So, while the headlines may startle, we believe there are numerous opportunities for diligent stockpickers to take advantage of historically attractive valuations.
Thomas Moore is Senior Investment Director of UK Equities at Aberdeen Standard Investments. Aberdeen Standard Investments manages six investment trusts that invest in the UK stock market:
Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments.
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