UK equities have been the ugly duckling in institutional investment portfolios for the best part of a decade. Ultra-loose monetary policy has favoured growth stocks and so has steered investors away from the asset class. Indeed, in the 10 years to the end of 2021, UK stocks booked £27.8bn of outflows, according to Lipper.
In a market environment where one simply has to buy a US equity index to book double-digit returns, why bother investing closer to home where equities have slumped and are surrounded by geopolitical and economic risks?
During 2021, defined benefit (DB) schemes reduced their UK equity exposure to 11.6% from 13.3%, according to Mercer. This has also been driven by a general trend towards de-risking with overall DB equity allocations slumping to 19% from 61% in the past 10 years, according to the Pension Protection Fund’s Purple Book. Even defined consideration (DC) schemes are not showing much appetite for their home market, with most of their portfolios invested in US stocks.
A global index
Concerns around Brexit may have accelerated this trend. Yet one argument in favour of UK plc is that the biggest firms in the FTSE100 are multi-nationals, such as Shell, Rio Tinto and AstraZeneca, catering to a global market. With some 70% of FTSE100 company earnings coming from outside the UK, have investors overestimated the Brexit risk?
Jonathan Cunliffe, managing director of investments at BC&E, the provider of the People’s Pension, is broadly optimistic about the global economic outlook and believes this could benefit UK stocks. The master trust has about 8% of its default strategy in domestic equities.
“As far as overseas earnings are concerned, with the increased transmissibility and reduced virulence of Omicron, the fact that we will likely end up in an endemic rather than pandemic, the outlook for the global growth environment is actually quite positive this year,” he says. “That is not properly priced in as people worry about inflation and rising bond yields. That tends to be constructive for the part of the FTSE All Share that is linked to overseas earnings.
Having said that, the UK economy is also in a reasonable position, notwithstanding Brexit headwinds. That means the small and mid-cap domestic earners could also do quite well. So, for the months ahead, the outlook for UK equities is broadly positive,” Cunliffe adds.
Others are more cautious. Dewi John, head of research for UK and Ireland at Lipper, believes the economic consequences of Brexit have yet to unfold. “It is estimated that the economic impact of Brexit will cost the UK economy twice as much as Covid, so it is a gift that keeps on giving. “We do not have the free-trade agreements that people were hoping for so you have rising costs of trading. Overall, that is going to reduce your competitiveness and will exacerbate inflation in the short and medium term,” he adds. “The effects of Brexit are not going away.”
This view is embraced by James McLellan, senior portfolio manager at Border to Coast Pensions Partnership. The £34bn local government pension scheme pool has an in-house managed UK equity strategy with a lower risk-return profile as well as an externally managed UK equity strategy with a higher risk-return profile.
McLellan argues that while the FTSE100 as a global index is reasonably hedged against Brexit risks, investors would do well not to underestimate domestic challenges. “It should be remembered that there remains a significant number of companies with exposure to the UK economy, and thus to the potential effects of Brexit, particularly amongst smaller companies. So, one can build a balanced portfolio or tilt the portfolio to be more or less exposed to the UK economy,” McLellan adds.
Yet the economic outlook is improving with the IMF estimating that the UK’s GDP will expand by 4.7% this year.
Factor rotation
Brexit aside, the factor that could benefit UK equities in the medium term is the same issue that led to their underperformance in the first place: a changing macroeconomic environment. Only now it is set to benefit value and income factors over growth. The combination of rising prices, rising interest rates and higher commodity prices could bolster the FTSE, where financials and energy stocks play a much larger role, Lipper’s John says. “There is a distinction to be made between income and value effects.
“Although many income-paying stocks are also value stocks, there are differences in income and value effects, particularly in the current inflationary environment. Higher interest rates have a more negative impact on growth stocks because stock valuations are premised on the current value of future cash flows. For many growth stocks, the emphasis is very much on ‘future’, so higher rates will have a greater discounting effect, the further in the future they are anticipated to be. On the other hand, higher inflation also devalues the real value of dividends [and so can impact the value of the stock], if and until their nominal value of those payments increases in line with inflation,” he adds.
The People’s Pension’s Cunliffe is also optimistic. “FTSE All Share has a relatively high degree of cyclical assets and we are in an environment where we will see much more synchronised economic growth and higher inflation. “That should benefit assets which are cheaper, have lower price/earnings ratios and are less vulnerable to the type of price/earnings contractions you might see if bond yields overshoot on the upside.
“Over the long term, secular growth stocks tend to win out. But for the time being, we are quite happy with our position,” Cunliffe says.
LGPS Central is another pension pool with significant investments in UK stocks. It holds 8% of the funds it has pooled in its Global Equity fund. For Mark Davies, LGPS Central’s investment director of active equities, this is the result of the pool’s internal setup.
“In our Global Equity fund, we have quite high exposure to value and are overweight Europe, particularly the UK. This is because as our partner funds have merged their country allocations into a global approach, there were few asset managers that offered a dedicated UK active equity fund. “This tends to be more of a bottom-up approach,” he adds. “We see significant value in some companies, not so much in the UK market as a whole.”
Dividend boost
Dividends have historically been the strongest selling point for UK equities. Compared to US stocks, firms in the UK tend to be more established and offer a regular stream of income. On average, FTSE100 dividends tends to be twice as high as that of the S&P500.
And this trend is likely to accelerate with rising commodity prices and rising interest rates which are set to benefit mining companies and financials, two key components of the UK’s blue-chip index. Indeed, UK dividends surged by 46.1% during 2021, handing back a total of £94.1bn to shareholders, according to Link. However, these payments were heavily concentrated among a few firms, mining in particular, and were boosted by one off pay-outs. For ESG funds, which might exclude mining stocks, the picture looks different.
For 2022, Link predicts dividend growth will slow down to £87.5bn as special dividends will be lower. Nevertheless, Border to Coast’s McLellan is confident that the current market environment will continue to benefit dividend streams.
“Dividend yield is often closely associated with value, and so to the extent that an economic recovery stimulates an increase in inflation and raises the appeal of value stocks, then the UK market would likely benefit since it looks cheap relative to other global markets,” he says.
Another factor to consider is the listings review by Lord Jonathan Hill, which is aimed at reversing the fortunes of UK stocks following a decade of outflows. Lord Hill proposes, among others, the introduction of a dual share class structure similar to that found in the US. Liberalising rules for free float requirements and special purpose acquisition companies (SPACs) we also recommended.
But will these measures make UK stocks more attractive? McLellan argues that the full effects of these reforms will only unfold over the long term. While he believes that they should, in theory, improve competitiveness, he warns that they could also have side effects for transparency. “One of the proposed reforms might also be considered to weaken the disclosure requirement for new issues and also potentially weaken the ability of shareholders to influence the behaviour of companies and so will place increased importance on investors conducting thorough research themselves and paying even closer attention to governance structures and practices,” he says.
Davies believes that if implemented, the listings review could fundamentally alter the composition of the FTSE. “This should allow those tech firms to become eligible for benchmarks and the index will not be as reliant on the old economy and become more attractive to institutional investors,” he adds.
Outlook
Does all this mean we will see a revival of UK stocks? For Davies, it remains important to be selective. “From a manager’s perspective, we are seeing the best value in financials and consumer staples like Tesco and Lloyds. “For us this is not so much about country allocation, we are active managers looking at this from a bottom-up perspective and weighing up the Tescos versus the Walmarts. Measured against that global benchmark, we are seeing greater opportunities in the UK.”
While Cunliffe is optimistic about the short-term outlook, he admits that there are potential headwinds. “We are broadly happy with where we are and our direction of travel. But over time, we will look towards reducing our exposure a bit. When we start getting into an environment where there is a bit less policy support, investors will want to pay a premium for earnings delivery. “The point at which bond yields may have peaked may be the point where we will consider reducing our position,” he says.
