Over to Gervais Williams and Martin Turner with the outlook for UK equities
Gervais Williams and Martin Turner, managers of The Diverse Income Trust plc, draw parallels between a damp and unpredictable summer of weather and the sentiment that has weighed upon UK equities. But are there sunnier times ahead?
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How has your summer been?
The sunny promise of June was quickly replaced by the gloom, drizzle and general unseasonable dampness of July and August. Whilst not meteorologists, we were left wondering why the weather was so bad in the UK this year and found ourselves drawing a comparison between this summer’s weather and the fortunes of the UK stock market over the last decade. But maybe it’s time to take a closer look and find the silver lining within the clouds surrounding UK equities (company shares).
Prevailing groupthink trade winds
Before identifying what we believe to be a very positive long-term opportunity, we need to understand what has caused the build-up of the cumulonimbus around UK equities. There is a useful rule-of-thumb in economics that when all the experts agree on something, you should start to question whether they are right. The reason is that economics, more than most disciplines, suffers from ‘groupthink’.
Groupthink is a psychological phenomenon in which individuals within a group prioritise consensus over personal doubts. It is why people will sometimes willingly set aside their own knowledge or experience and follow the ‘wisdom’ of the crowd. Financial markets are uniquely vulnerable to groupthink. There is a working assumption that share prices are normally right because they reflect the balance between willing sellers and willing buyers, meaning that when certain groups of company shares outperform, investors often have faith there is a rational explanation for this performance.
There is little doubt as to the stars of world stock markets in recent years. The US has led the way, with technology companies to the fore, led by the so-called ‘FAANG’ company shares of Facebook, Amazon, Apple, Netflix and Google. Arguably their rising share prices have provided evidence of a classic groupthink bias whereby investors extrapolate their future expectations from recent share price trends.
A more rational appraisal of stock markets would indicate that valuations of growth company shares may have priced in the expectation of ever-higher future earnings. History suggests this cannot last forever. Current market movements may therefore be a precursor to other areas of the market outperforming whilst expensive growth company shares fall back to lower valuations. Could UK equities be a beneficiary of this shift?
The QE jet stream
Quantitative easing or QE entered our collective vocabulary during the global financial crisis when central banks purchased assets, such as bonds, to reduce interest rates, increase the supply of money in the financial systems and drive banks to lend to consumers and businesses. The goal was to stimulate economic activity during the financial crisis and keep money moving.
However, post financial crisis QE continued to flow. During globalisation, central banks have been able repeatedly to deploy financial stimuli, keeping interest rates low and introducing the furlough schemes seen in the UK during the Covid pandemic. But every action has an equal and opposite reaction. By favouring those with access to the lowest cost debt – typically the largest companies in the stock market – QE has come at the cost of distorting bond and equity market prices and this in turn has changed company and investor behaviour.
The net effect is that that large company shares have delivered strong returns relative both to inflation and to the broader equity indices, greatly favouring the large technology companies in our view.
And so, the storm clouds built
QE mixed with groupthink could spell trouble. During the years of QE, low-cost index funds, which “track” major stock market indices such as the S&P 500 Index, have delivered excellent long-term returns and for many investors have become a core part of portfolios. So-called passive strategies are self-fulfilling in nature because they automatically allocate the largest proportion of invested capital to the very largest companies on a stock exchange or index, and in doing so drive-up valuations of large technology company shares even further. Passive investment strategies are sometimes called index investing. Index investing is perhaps the most common form of passive investing, whereby investors seek to invest in a broad market index.
In this context, groupthink may have lulled investors into a false sense of security. If economic conditions become more testing, the more mainstream asset returns may disappoint, especially those dominated by large sized company shares, and those standing on elevated valuations. Where would UK equities stand in such a scenario – buffeted by the winds of economic downturn or a proverbial port in a storm?
It’s raining while the sun is shining
We believe that now is an important time for investors to review their investments, given the change in the interest rate backdrop. This shift is likely to mean that what performed well in recent decades may not necessarily perform well in the next decade.
Historically, UK equities (as represented by the FTSE All-Share Index) outperformed US equities (represented by the S&P 500 Index) during the period of rising interest rates from the mid-1960s to the mid-1980s. While as an industry we are always clear that past performance is not a guide to future performance, what can we deduce from this trend.
From 1965 to 1985, a period that was characterised by higher inflation and higher interest rates globally, the UK stock market substantially outperformed the US stock market. In the following three decades it subsequently underperformed its US counterpart.
Valuations of large UK company shares were broadly in line with those of the rest of the world in 2016 but have since moved decisively lower. Some commentators have suggested that the sector mix of the UK stock market might explain this difference, the relative absence of the technology companies that have increasingly dominated the US stock market, but even when UK company valuations are compared with similar company shares quoted elsewhere, they are still valued lower than international peers.
The outlook for UK equities looks brighter
Having lived with falling interest rates for over 30 years, we believe we are now entering a period of more normal interest rates. Because QE may have distorted market prices and portfolio allocations over the last fifteen years, market trends may be set to change dramatically in the future. If economic conditions do get tougher, companies generating surplus cash and paying dividends could prove more resilient, a good reason why UK equities may look well placed.
To summarise our investment weather forecast, UK equities currently look attractively valued in our view, and combined with their potential to generate good and growing dividends we believe there is a historical precedent for potential future outperformance.
From a large company perspective, we are finding lots of opportunities to invest in international leaders based here in the UK. Within UK smaller companies, the opportunities may be even more marked, as investors start to find this area of the market attractive. It is hard to understate the magnitude of the change at this end of the stock market after three decades when investors have been near-permanent sellers of smaller company shares.
When smaller sized companies thrive, they create local skilled employment, drive local productivity improvement, and ultimately pay increasing taxes to the local exchequer. If anything, therefore, the health of capital flows into smaller sized UK companies is more important to the UK government than that of larger sized UK companies. The chancellor specifically voiced these points in his recent Mansion House speech. Alongside this, at Premier Miton we are proposing that a portion of annual ISA investment is allowed exclusively for companies listed on UK stock exchanges. Judging by subsequent press comments, the chancellor may be set to announce a change along these lines in his Autumn Statement in November.
If he does so, we would see this as a potential game changer. Increased UK ISA flows along with growing enthusiasm from private investors for UK smaller sized companies have the potential to transform investment flows into this area of the market. This may all add up to a strong long-term case for investment. UK equities across the company size spectrum may have fallen out of favour with many investors over the past decade or so, but we expect both sunnier weather and investment in the UK to return.