Since the beginning of the year, the UK equity market has been struggling to digest two trends – the persistent and elevated levels of inflation and the implications for interest rates and central bank actions.
Markets show expectations of reduced growth this year, with concerns that the Bank of England may go too far in raising interest rates, triggering a recession. Thus, cyclical areas of the market — such as retail, travel and leisure, and industrials — have seen their share prices sell off recently as the market has been trying to price in a possible slowdown.
Furthermore, with discount rates being very sensitive to interest rates, increasing interest rates resulted in a de-rating (investors reducing the multiple that they are prepared to apply to a company’s earnings to value the equity) of long-duration equities. This scenario has caused a sharp drawdown in growth stocks year-to-date, as witnessed in the tech laden US NASDAQ Composite Index.
Assessing the outlook for equity markets in the second half of the year, the Martin Currie UK Equity team1, part of the Franklin Templeton group2, responsible for approximately £5 billion in assets, looks at the main headwinds and tailwinds facing investors:
Signs of optimism in the bleak growth outlook
Ben Russon, Portfolio Manager, Martin Currie UK Equity, comments: “The UK consumer is facing a cost-of-living crisis, with rising energy prices, national insurance increases and rising mortgage rates just some of the factors that are putting a squeeze on disposable income. Despite recent negative headlines, we believe there are opportunities in UK equities where the market has been too pessimistic. Approximately £250 billion worth of excess savings was built up in 2020-2021 over the lockdown period when people were prevented from spending on services or experiences.”
“Analysts are debating whether these savings will come back into the economy or not, which is causing differences in UK growth forecasts. Nonetheless, that money is there, and we believe it will eventually make its way back into the economy in some shape or form.”
“Despite rising interest rates, mortgages remain affordable across the United Kingdom. Average mortgage payments as a proportion of disposable income are at the lower end of their historical ranges. Housing price corrections occurred after the 1991 and 2007 peak periods when mortgage payments became a significant chunk of people’s disposable incomes, but current projections show that mortgages remain affordable. Additionally, most mortgages are fixed either for two or five years, so it will take time for changes in mortgage rates to impact spending power.”
UK consumer confidence supported by strong economic fundamentals
Russon continues: “UK consumer confidence is predicated on the value of people’s homes, their largest assets, and how secure they feel in their employment. Recent data shows unemployment at record lows and job vacancies at record highs. There are currently more job vacancies than there are job seekers. Thus, even if the economic waters get a bit choppy, at least the United Kingdom is starting the journey from a position of relative economic strength, given the robust nature of the UK employment market. Strong long-term wage growth is another factor counteracting the cost-of-living crisis. Thus, nominal wage increases will help consumers keep pace with rapidly rising prices.”
A new Prime Minister will face spending dilemmas
Russon adds: “Equity and Sterling markets have been very sanguine about the political turmoil that has been playing out in recent days, albeit the currency had already been weak versus the US dollar in recent months, so arguably had less scope to fall further. Clearly with eight leadership candidates remaining, there is a broad spectrum of possible outcomes, with fiscal discipline (or otherwise) being the most relevant factor for domestically-exposed UK equities.
“Ideologically the Conservative Party has already been wrestling with the need to spend on health, defence, levelling up etc versus the desire to be a low-tax political movement. There are several important fiscal decisions to be made, not least being whether to proceed with the imminent rise in corporation tax. Coupled with the ongoing conflict regarding our trading relationship with Europe, a new Prime Minister and his/her team have some big calls to make.”
Large caps provide safe haven in volatility, while UK dividends remain resilient
Jo Rands Portfolio Manager, Martin Currie UK Equity comments: “The FTSE 100 Index has been relatively strong compared to global equities year-to-date. The large cap focused index has benefitted from large weightings in sectors positively correlated to inflation and rising bond yields such as oil and gas, mining and banks. Plus, decent exposure to more defensive sectors such as utilities and pharmaceuticals, has also helped in an environment where investors are fearing a slowdown. In addition, the UK market overall trades on lower valuation multiples than the likes of the US, again this has proven supportive, especially against a backdrop of rising bond yields. The FTSE250, however, has also struggled, as it is dominated by industrial cyclicals and consumer discretionary – areas of the market at risk from an economic slowdown.”
“Over the last year, we have seen a recovery in dividend payouts across the UK market which, was driven by the banks and miners. Moreover, an interesting development in 2021 was the number of special dividends, which was approximately three times higher than average levels. This was driven by the miners who directly benefitted from high commodity prices, and more broadly, businesses making asset sales and returning cash via specials.”
“The miners in particular have been showing good capital discipline, and we’re still seeing capital expenditures around recessionary lows. Furthermore, although commodity prices are expected to fall back from here, forecasts across the market still assume that miners will continue to be a significant dividend contributor in 2022. Banks and oil majors are also expected to be important drivers of dividend growth for the UK market this year.”