The outlook on the UK has been upgraded to “neutral” from “negative” by UK investment manager Brooks Macdonald on valuation grounds – even as the possibility of further Brexit uncertainty looms in the form of a House of Commons vote on the Customs Union later this week.
The Parliamentary debate and vote comes after the UK’s House of Lords, the upper chamber in the bicameral system, last week voted to reject the current UK government’s proposals to leave the Customs Union as part of the Brexit process.
That has forced the debate to return to the lower chamber. The official view from the UK government is that it will still push for exit from the Customs Union and that the vote last week in the House of Lords does not change this view.
Edward Park, Brooks Macdonald investment director, suggests that on valuation grounds the UK remains attractive.
“As the US Federal Reserve continues to withdraw stimulus, the reduction in liquidity and tightening of monetary conditions has led to a marked uptick in equity market volatility, which has also been evident in rates with an uptick in the Libor-OIS spread (traditionally a proxy for inter-bank stress).”
“With this backdrop, equity investors have been prone to focus on possible downside factors far quicker than when the ‘central bank put’ was viewed as a major supporter of sentiment. In February there was concern over the future path of rates after a higher than expected US wage growth number and most recently, this concern has centred on the increased risk of a Sino-American trade war. We think the central bank backdrop now means that downside risk is more acute than in previous years, particularly 2017 which benefited from accommodative policy support at the same time as we saw strong growth in economic and corporate data.”
“Given this riskier backdrop it is increasingly important that fundamental data supports market levels. The Q1 US earnings season is now underway and the market is expecting 17.1% earnings growth though this is partially distorted by the one off effects of US tax reform, revenue numbers also suggest corporates are in good health.”
“This occurs at the same time as the US index has re-rated quite significantly, now trading on around 16.5x next twelve month earnings, making US equities attractive on an absolute basis but also compared to European equities which, sector adjusted, are trading on similar multiples. US and European (particularly the latter) soft data has missed expectations in Q1 however these figures still suggest momentum remains intact and should be read in the context of the extremely high levels figures such as the PMIs were printing. US Q1 growth has also been difficult to seasonally adjust for in recent years with US government shutdowns, weather, strikes and other factors meaning that there are regular ‘one off’ issues.”
“Our base case with regards to the risk of a trade war is that the uptick in rhetoric is largely designed to bring China to the negotiating table in order to resolve some outstanding issues such as intellectual property infringement and the enhanced WTO terms that China receives as it is still classed as a ‘developing nation’. As with any political situation there is a risk that this boils over into something more significant, however we take note of recent comments from both sides that suggest a thawing in the relationship. The timing of this, ahead of the midterm elections is also important and it encourages a certain degree of sabre-rattling particularly if it pleases Trump’s core demographic. The change in White House staff is potentially more concerning for the longer term and may herald a harder line towards China and protectionism more broadly which is an area we will be monitoring.”
“Overall we retain our neutral equity weightings though may look to reduce equity as we see opportunities. On valuation grounds we have upgraded the UK from a negative outlook to neutral and downgraded Japan and Europe from positive to neutral. Whilst UK equity markets now appear ‘cheap’ we are conscious that the domestic consumer remains highly levered and has a low savings rate suggesting a poorer outlook. We have also upgraded International Sovereign bonds from a negative outlook to neutral given reduced concerns over inflationary pressures and given recent rises in core government yields.”
Brexit continues to be a risk to consumer sentiment in the UK. Last week it was reported by the BBC that a meeting between UK and EU negotiators saw severe criticism of the UK’s proposals for the border between Northern Ireland and the Republic of Ireland. Both sides have previously suggested that if there is no deal on the border issue, there will be no final deal accepted.
Also, the UK Parliament’s Business, Energy and Industrial Strategy Committee, highlighted dangers to the country’s food and drink industry, considered to be the largest manufacturing sector, employing some 400,000 people. The Committee stressed the importance of striking a free trade deal with the EU.
However, it is not only Brexit causing concern; expectations are growing of interest rate rises, amidst rising wage pressure and concerns about to what extent levels of excess capacity in the economy are being squeezed
Wages are not the only source of income, and evidence from the latest UK Dividend Monitor from Link Asset Services (formerly Capita Asset Services) suggests UK dividends rose just 1.2% in Q1 2018 – once one-offs were taken into account.
The headline total reported of £16.7bn, up 7.6% year-on-year, was distorted by a £1bn timing fillip from British American Tobacco (BAT), which switched to quarterly payouts as part of its absorption of US tobacco firm Reynolds, the Dividend Monitor states. Also, while dividend yields may have risen in the quarter, this reflects falling share prices, it adds.
And incomes from dividends continue to suffer concentration risk; almost a quarter of the total first quarter dividends were paid by the oil majors Shell and BP. But, higher oil prices have not yet led to higher payouts. This is blamed on the fact that they continued to pay dividends when the oil price slumped, so are not not increasing the dividends even as the oil price stabilises or increases. And exchange rates have hit the sector hard, as the Dividend Monitor suggests that in sterling terms, the total dividends from the oil sector decreased 15.3% YoY.
However, all things considered, the expectation for the full year 2018 is that dividend payouts “will set another record” according to Justin Cooper, chief executive of Link Market Services, part of Link Asset Services.
“Investors shouldn’t be worried, however. If you take exchange rates out of the picture, dividend growth will continue in 2018 only a little slower than last year.”