Examining why the UK equity market looks amongst the most attractive compared to its developed market peers.
Why the UK is one of our favourite market plays
All developed markets have had an extraordinary run-up since the last financial crisis and some have been exhibiting signs of overvaluation for a while. Yet, investors seem to be looking past this as they have nowhere to place their funds for decent returns given the ultra- low interest rate environment. The S&P 500 is the best example of this given that it is trading at roughly 23x forward earnings, this compares to an average of around 17x since 2006. These signs are not just seen in fundamentals based data but also in technical analysis as well as macro-economic data. The market run-up since the trough induced by Covid-19 and all the unprecedented levels of fiscal and monetary stimuli is supportive of higher inflation expectations which is beginning to be seen in some economies and asset prices such as commodities.
However, on a relative basis, both Europe (excluding UK) and Japan look healthier. The Euro Stoxx 50 for example is currently trading at 19x forward earnings compared to a historical average of around 14.5x. However, when drilling down further, it seems it is more to do with a poor macro backdrop making the fundamentals data look more attractive.
Looking at the UK, return on equity has been poor by absolute and relative standards; the FTSE 100 is still trading below its pre-pandemic level. Even before this pandemic when it hit all-time highs, its gains were materially behind other markets, this could be partly attributed to Brexit but also the UK market’s concentration on financials, energy and mining which were going through some difficult periods.
With a confluence of factors, the UK equity market now looks amongst the most attractive (on multiple valuation measures) compared to its developed market peers. The FTSE 100 trades at roughly 15x forward earnings, though still higher than its historical average at around 14x, I believe this should be taken as confidence in the UK market outlook though.
The UK market has not taken part in the global rally as much as others, given that concentration to the tech sector is so low. But with the UK’s leading vaccination programme the great re-opening is in sight and I believe investors will begin to rotate their portfolios back towards value for which there is an abundance of stocks and sectors in the UK.
The leading banks all cut their dividends last year and they made provisions for the looming wall of bad debt. However, the results published so far show that they have been overly cautious on bad debt provisions; profits were not as bad as feared and all have announced plans to return to paying dividends and they all have balance sheets that are far healthier than a decade ago.
The big oil stocks are recovering along with the underlying price of oil which is once again materially above the cost of production. Their dividends were cut, but is likely to grow again. Meanwhile the big mining stocks are having the best time of it for many years. The Chinese economy continues to grow, while around the world more fiscal spending is going towards infrastructure spending and the electrification of cars and the working-from-home culture creates new demand for commodities such as copper. The insurance companies have been resilient while the big pharmaceuticals will expect to see prescriptions rates and drugs sales return to normal.
These are all traditionally high yielding sectors which partly contribute to the UK markets higher yields compared to other international markets as well as the culture of generally higher pay-out ratios. Last year’s dividend cuts though took the index’s yield down to around 3.2%, the lowest since 2010 while the historical average is around 4.2%. The consensus view amongst analysts is that dividend yields will return to the historical average by around 2023.
The UK stock market looks compelling but there are still many clouds on the horizon. We have only just begun to experience what Brexit really means even though its effects have been blurred in with the impact of Covid-19. Certain sectors will never get back to their previous status such as the retail sector while the economic situation is not entirely rosy. Unemployment has just hit above 5% and is set to rise in due course when furlough schemes come to an end. This is likely to have a depressing impact on consumption rates while savings rates are elevated and likely to remain so for some time.
However, the UK stock market (especially the large cap) is international in nature and there is, to some degree a disconnect from the economic reality in the UK. Sterling’s movements provides a natural hedge for UK listed companies and the central bank is still in an ultra-accommodation mode. I therefore see the UK stock market as one of the most attractive places for equity investments.
All information given including prices, yields and our opinion is correct at the time of publication. Our opinions on investments can change at any time and for our latest view please go to www.share.com. To understand how our Investment research team arrive at their views please read our Investment Research Policy.