Feature – UK equities
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 B&CE, the provider of the People’s Pension, is broadly optimistic about the global economic outlook and believes this could ben- efit 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 posi- tion, 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 posi- tive,” 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 we have rising costs of trading. Overall, that is going to reduce your competitiveness and will exacerbate infla- tion in the short and medium terms,” 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 man- aged 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, inves- tors 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 econo- my,” McLellan adds. Yet the economic outlook is improving with the IMF estimat-
40 | portfolio institutional | February 2022 | issue 110
ing that the UK’s GDP will expand by 4.7% this year, making it the fastest growing economy in the G7.
Factor rotation Brexit aside, the factor that could benefit UK equities in the medium term is the same issue that led to their underper- formance in the first place: a changing macroeconomic envi- ronment. 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 finan- cials and energy stocks play a much larger role, Lipper’s John says. “Although many income-paying stocks are also value stocks, there are differences in income and value effects, par- ticularly in the current inflationary environment. Higher inter- est 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.” The People’s Pension’s Cunliffe is also bullish. “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 over- shoot on the upside.
We see significant value in some companies, not so much in the UK market as a whole.
Mark Davies, LGPS Central
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