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17 March 2021

There can be no doubt that 2020 was a difficult period for UK equities. Whilst all markets were troubled by the pandemic and economic lockdown, the UK suffered more than others. The market was penalised for a number of reasons. Firstly, the UK is renowned as a dividend paying market. As companies were forced to close their doors, dividends were either reduced or suspended. Even some industries where the companies within would have been capable of paying dividends, such as banks and insurance companies, they were unable to do so due to the restrictions placed on them by regulators.

The UK market also struggled in the post March rebound due to the sector allocations within the index itself. The main UK indices have a small exposure to technology, the winner during the stock market recovery, unlike other markets, such as the US in particular. Instead it has a higher exposure to more cyclical sectors such as basic materials, industrials, financials and consumer services. These were all areas which were either hit hard by economic lockdown or dividend cuts.

That lag in performance however left UK equities trading at a substantial discount to other markets. As at the 31 December, the UK was trading at a 41% (source: Morgan Stanley) discount to the rest of the world on a combined valuation basis using price to earnings (PE), dividend yield and price to book value. Even excluding banks and energy the UK was still trading at a c. 30% discount (source: JP Morgan). Relative to the US those valuations were even more extreme. The FTSE All Share relative to the S&P 500 traded at a low not seen since 1975 (source: Macrostrategy Partnership), whilst on a price to book value basis, the UK was trading at half that of the US (source: JP Morgan).

Valuation differentials were not just driven by index composition however and even global companies listed in the UK who operate in more growth areas of the market were valued at a marked discount relative to their overseas peers. For example, GlaxoSmithKline at the 31 December traded on a PE ratio of 11 times, compared to Novartis on 16 times earnings and Novo Nordisk on 23 times earnings. Imperial Brands traded on a PE ratio of 6 times earnings whilst Philip Morris International traded on 16 times earnings. (source: Columbia Threadneedle)

UK equities were also cheap relative to their own history, or certainly cheaper than other regions. Relative to its own history of the last 15 years, the UK traded at its 56th percentile as the end of 2020. This compared to the 100th percentile for the US, 93rd percentile for Europe ex UK, 92nd percentile for Japan and 95th percentile for the Emerging Markets. (source: Bloomberg/T Rowe Price)

Since the end of October 2020 we have seen a turnaround in the performance of UK equities, coinciding with the rollout of vaccines which came with much higher efficacy rates than expected. To the 17 March the IA UK Equity Income sector average has returned 27.34% whilst the IA UK All Companies sector has returned 25.93%. Other regions have also delivered positive returns but they have proven laggards compared to the UK, with IA Europe ex UK delivering 18.19%, IA Global Emerging Markets 16.51%, IA North America 14.93% and IA Japan 12.00%. (source: FE Analytics)

The vaccine rollout has driven hope that economies will be able to return to normal. Those companies and sectors that proved to be laggards in 2020 may therefore prove to be the winners moving forward. This suits the composition of the UK index as discussed earlier which is more cyclical in nature. Also contributing to the outperformance of the UK more recently has been the rising inflation expectations, with market participants moving away from their deflationary stance. This has led to an increase in bond yields, although more so in longer dated maturities, with the yields on shorter dated maturities anchored by low base rates, where central banks appear in no rush to increase them any time soon. This again suits investments which are more cyclical/value orientated in nature. For example, bank share prices have a high 0.8 correlation (source: Refinitiv Datastream) with 10 year bond yields, i.e. as bond yields rise, so do bank share prices. Therefore, the UK market as a whole has a higher correlation with such bond movements, especially compared to those markets which are more growth or quality orientated, such as the US and Switzerland.

The UK market has also been helped by a resumption in dividends being paid by companies who did not during 2020. For example, we have seen banks return to the dividend register, such as Lloyds and Barclays, with the latter also planning to conduct a share buyback program. The return of dividend paying improves their total return outlook and therefore increases the chances of their share prices rising and valuations re-rating. The dividend per share growth is forecast to be the second largest this year of major equity regions, eclipsed only by European companies. Whilst it is expected that it will take some time to return to the level of dividends paid in 2019, this should all the same be taken as a positive.

Last but not least, whilst some issues still remain unresolved, the last minute agreement to a Brexit agreement with the EU should not be forgotten. For overseas investors this had clouded the outlook for the UK considerably, with overseas fund managers consistently maintaining an underweight position. With that uncertainty now removed, we may see overseas investors tempted back in to the market. Given valuations levels, we have already seen corporates take an interest, with merger and acquisition activity involving RSA Insurance, William Hill and McCarthy & Stone.

Despite this recent outperformance the UK still remains attractive on a valuation basis. As at the 11 March, MSCI UK traded on a forward PE ratio of 13.7 times earnings. This is cheaper than the US which trades on 22.2 times earnings and whose valuation has never been as high since 1999. The UK also remains cheaper than Japan, Europe and Emerging Markets, whilst also being below its own highest reading since 2006. This latter point can not be said for Emerging Markets or Europe. (source: Refinitiv)

If the reflation trades continues as economic growth recovers then value and cyclical companies may continue to outperform. This should be a positive for the UK and tempt investors back into a market they have given less attention to of late. One final note on currency which may also have an impact. Whilst sterling has already appreciated since Brexit clarity was provided, it still potentially remains undervalued relative to both the US and Euro on a purchasing power parity basis. Whilst a closing of this discount and further sterling strength may be a negative for the overseas earnings of UK companies when translated back to sterling, a stronger currency could prove more attractive for overseas investors and tempt them back to our shores.

As always uncertainty remains, but it was interesting this week to see that a fund manager survey no longer had COVID as the number one risk, although admittedly it was still in the top three The tide appears to have turned for UK equities and long may it continue. 

This article is for information purposes only and should not be construed as advice. We strongly suggest you seek independent financial advice prior to taking any course of action.

The value of this investment can fall as well as rise and investors may get back less than they originally invested. Past performance is not necessarily a guide to future performance.

The Fund is suitable for investors who are seeking to achieve long term capital growth.

The tax treatment of investments depends on the individual circumstances of each client and may be subject to change in the future. The above is in relation to a UK domiciled investor only and would be different for those domiciled outside the UK. We strongly suggest you seek independent tax advice prior to taking any course of action.

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