Beyond Brexit: The outlook for the UK economy is better than market valuations imply

Eugenia Jiménez
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Beyond Brexit: The outlook for the UK economy is better than market valuations imply

We believe that the economic indicators, robust corporate data and attractive valuations across a number of sectors make the UK equity market, an attractive place for the long-term investor. Currently, our portfolios are positioned to exploit UK domestic value and selective international growth income and highly cash generative stocks. Extended negativity priced-in to UK sourced revenues presents a value opportunity in domestically orientated stocks.

My 2018 outlook highlighted the power of macroeconomic forces to drive international markets such as the FTSE All-Share index. 2018 proved to be a year of extremes. Entering the new year, risks surrounding a global economic slowdown, US monetary policy, Sino-US trade wars and the rise of populism in Europe continue to dominate debate. At home, we stand at a political crossroads. Despite months of negotiations, fierce rhetoric and political pageantry, the nature of Britain's exit from the European Union remains in doubt.

Amid this sustained uncertainty, momentum has ruled. As investors have sought safety in dollar denominated earnings, bad news has been met with a heavy-hand and irrational market pricing has left many quality companies trading at historic discounts. The value of sterling meanwhile continues to act as a barometer for the market's confidence around Brexit. Despite some gains seen in the opening weeks of the new year, the pound remains significantly below purchasing power parity versus the dollar.

Macroeconomic developments have provided the opportunity to emphasise a number of key themes. Exposure to attractively priced UK earnings remains significant: my portfolios have more than twice the exposure to UK sourced revenues as the FTSE All-Share index. Dividend growth remains a priority, with international growth stories also featuring prominently. Non-correlated financials offer income streams that are not dependent on the traditional drivers of our economy, whilst the balance is invested in stock specific opportunities.

Looking across the UK equity market, we remain convinced that the glaring opportunity lies within domestically focussed names. It feels as though after an extended period of irrational market pricing, we may finally be at the point of change.

Potential catalysts for a reassessment of the underlying value within the market include, amongst other things; clarity on Brexit, improved global economic growth, and an end to the US-Chinese trade impasse.

We continue to maintain our long tested approach to active investing, which places an emphasis on stock selection, whilst seeking income generating opportunities at attractive prices.

The UK equity market

Despite the underperformance of the UK equity market versus international peers, the FTSE All-Share index has returned almost 20 per cent since the EU Referendum in June 2016. In aggregate the market might not appear excessively cheap, however headline data disguises the marked divergence between valuations of internationally orientated companies and those that source the majority of their revenues from the UK.

The devaluation of sterling versus the US dollar has seen companies with substantial overseas interests benefit, whilst UK domestic facing stocks have been hurt by rising US$ costs and lacklustre investor confidence amid sustained political uncertainty.

The scale of the markdown is significant. We are experiencing a level of pessimism not seen since the financial crisis.

We continue to believe that global investors are taking an extremely pessimistic view of the future for UK revenues and, or, the sustainability of margins. We believe this is overly pessimistic and fails to recognise the underlying health of the UK economy. Coupled with robust signals from many UK domestically orientated businesses, including those we meet with regularly, my assessment is that the outlook for the UK economy, and by extension domestically orientated companies, is better than market valuations imply.

The UK economy

Economic indicators belie the market's negativity, pointing to continued steady, if unspectacular, economic growth in the UK. We have seen a recovery in real wage growth over the past year; inflation is now at 2 per cent whilst wage growth is in excess of 3 per cent. It is significant that real wages are rising faster than they were falling just a year ago. The number of people in work increased by 350,000 in 2018, more than three times the increase in the size of the working age population. This near-record low unemployment is set against a backdrop of 850,000 job vacancies - a record high. Consequentially we expect employment growth to remain robust.

Further economic stimulus is likely to come from an uptick in government spending. Growth in real government spending has been minimal since the recession. Now that the budget deficit has fallen to less than 2 per cent of GDP and the current budget has moved into surplus, the government intends to step up its spending plans, as announced in the Chancellor's Autumn statement. Continued employment growth and growth in real wages should help to strengthen consumption growth. Coupled with an increase in government spending, we expect to see continued real GDP growth. This improved macro-picture is supported by company data. Following years of steady downgrades, businesses are forecasting more robust earnings growth.

The underlying strength of UK earnings has in part been supported by sterling weakness. If we look to dividends, long acknowledged as a key indicator of a company's financial health, yields have been particularly robust.

The gap between UK dividend and UK bond yields has extended. UK dividends have not been this cheap, in relative terms, for a hundred years.

Despite persistent negativity toward UK equities, economic and corporate data suggests that the economy has thus far proven resilient. Added to this, the forecast increase in government spending, announced in the Autumn statement last year and the Treasury's flexibility to provide further injections after Brexit, it feels reasonable to expect the UK economy to remain relatively robust in 2019. The first estimate of fourth quarter GDP showed resilience in household and government spending and a further fall in business investment, which can be expected to recover following a resolution to the current political impasse. We believe the combination of these factors set against the low valuations across a number of sectors makes UK equities an attractive place for the long-term investor.

Implementing cautious optimism in our portfolios through four themes:

Exposure to sterling revenues has been modestly increased as the drawn-out Brussels negotiations and UK Parliamentary debate have exacerbated the pessimistic consensus towards the UK. The exposure to stocks which offer an absolute return potential that is not correlated with regular business cycles has also been emphasised, largely through non-correlated financials. Exposure to global industries —namely oil and tobacco — remain prominent, as a market driven by short-termism and an emphasis on new disruptive business models in all industries have left companies trading at attractive valuations.

1. UK domestic value

One area of the domestic market that I believe offers evident value is real estate. As the market has capitulated under pessimistic outlooks for the UK economy, we have seen significant discounts appear within the sector. Two of our holdings for example, Derwent London and British Land, have been trading at depressed valuations since the EU Referendum, despite having provided investors with attractive yields.

2. International growth opportunities

Despite the tilt towards domestic value opportunities, our UK equity portfolios remain well balanced with significant exposure to the international earners of the FTSE All-Share index. My portfolios have notable investment in the integrated oil & gas sector. My focus as a stock picker remains on company fundamentals rather than the volatile oil price. The extent of work undertaken by the industry to improve the free cash flow is compelling. The oil price collapse has forced companies across the sector to pare back costs to adapt to the economics of a US$50-60 per barrel oil price. We believe the attractiveness of the energy sector is not dependent on a higher oil price, but rather in the ability of these companies to cover their cash flow and dividends.

Companies such as Royal Dutch Shell and BP, holdings in my portfolios, have succeeded in removing excess costs from production. Using technology, standardisation and simplification to reduce expenditure, the sector has driven down costs to such an extent that the cashflow breakeven cost of oil has been reduced from more than US$140 per barrel in 2013 to just over US$40 per barrel today. In effect the sector's cash flow yield is higher at US$60 oil than it was at US$120 oil. Correspondingly the ability of the industry to pay sustainable, covered dividends has meaningfully improved.

3. Tobacco - historically reliable income

The tobacco industry's enviable cash generation potential, high barriers to entry and historic commitment to generating shareholder income have been well suited to our core investment thesis, which seeks to provide investors with income and capital growth. Over the past eighteen months however, sentiment towards tobacco has soured, with concerns around regulation and the outlook for next generation technologies undermining confidence in the sector's ability to maintain these competitive advantages.

Having faced an increasingly hostile regulatory environment over the past three decades, tobacco companies have survived negative headlines, advertising restrictions and even smoking bans - proving their model for profit and cash generation to be resilient. More recent threats from the US Food and Drug Administration (FDA) have taken aim at nicotine and menthol in traditional cigarettes and the market has been further disturbed by the prospect of industry disruption, notably vaping firm JUUL in the US. We believe these threats are overplayed.

Regulation has been a key feature of the industry for decades. Recent moves by the FDA, if successful, are likely to take years to implement. Meanwhile, the prospect of a total menthol ban remains unlikely, given the requirement to evidence "additional harm" versus non-menthol products. Meanwhile, the tobacco majors are at the forefront of new technologies, with the resources to drive successful innovation in the sector. A viable next-generation offering has become a principal part of the long term strategy for the tobacco industry - reflected in the considerable investment made, and planned for, in ‘next generation' R&D. Where technology isn't built, it can be bought: Altria announced a US$12.8 billion 35 per cent stake in JUUL last December. I anticipate that the tobacco majors will remain at the forefront of the industry, as their capital base and experience of operating within a heavily regulated environment plays to their strength versus challengers in the market.

We believe current valuations offer too bleak an outlook of the industry's future. Whether it be through traditional products or next generation alternatives, I remain confident that tobacco will remain a highly profitable and cash generative industry. As companies continue to focus on pricing power, cash conversion and product innovation, they should also continue to provide a reliable source of income and capital growth in the long term. Coupled with the historic commitment of company management to return cash to shareholders as dividends - they may be expected to continue to play a significant part in the portfolios under my management.

4. Non-correlated financials - diversified income

Amid challenging and uncertain market conditions the need to secure diversified income streams remains crucial. Non-correlated financials offer strong cash flow and income generation potential, where earnings growth is not dependent on traditional business cycles.

The UK equity market has traditionally offered an attractive, but concentrated income profile; a narrow range of main index names provide the majority of contributions. Exposure to non-bank financials is one method of generating income for the portfolios which is not correlated to the traditional drivers of our economy or the performance of the FTSE All-Share index.

Conclusion

As we move through 2019 macroeconomic factors both at home and abroad will no doubt continue to influence the performance of equity markets. However, as I anticipate a revision to more rational pricing, I remain confident that my portfolios remain well diversified, with a range of income generating companies, which trading at attractive valuations offer opportunity for income and capital growth. Potential catalysts for any reassessment of the UK equity market's prospects must surely include a better-than expected outcome for Brexit. We believe a positive outcome for the UK equity market rests on an end to the political no-man's land which has perturbed investors for the past two years.

Mark Barnett, head of UK Equities at Invesco