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UK equities: another year to buy British

The key feature of the UK stock market in 2015 was the underperformance of large-caps. Unless commodity markets turn, expect more of the same next year
December 18, 2015

Five years ago, when the UK economy was mired in recession, investors took comfort in the international flavour of the London stock market. Now the situation is reversed: the UK economy was among the fastest growing in the developed world in 2015, but anyone invested in a tracker fund will have been reminded that UK stocks are a poor proxy for UK growth. As of mid-December, the FTSE All-Share index - the most comprehensive of the benchmarks that track the performance of UK shares - is down 2.4 per cent over the year.

Fortunately, this figure understates the returns most UK stockpickers earned in 2015. For a start, the City's dividend culture is the strongest in the world, so it would be a mistake to ignore shareholder payouts: factoring them in, the so-called annual total return on the FTSE All-Share rises to 1.1 per cent. Moreover, inflation is currently in negative territory, with consumer prices down 0.1 per cent over the year to October 2015. That suggests the real total return on all UK stocks has been about 1.2 per cent over the past year. Admittedly, this is still slightly lower than the average interest rate on a bank savings account.

But even this figure is misleading, as few investors - least of all Investors Chronicle readers - own all stocks. The index is capitalisation-weighted, giving large companies an almost overwhelming prominence. FTSE 100 groups account for about four-fifths of the FTSE All-Share, leaving the 'mid-cap' FTSE 250 with 17 per cent and the remaining 290 or so small-caps in the index with just 3 per cent. That means the index looks very different to the portfolios of most fund managers or private investors, who tend to place as much emphasis on smaller companies.

This size effect matters because smaller companies outperformed their larger peers by a huge margin in 2015, which is unusual for a year in which investors became more risk-averse. Including dividends, the more domestically focused small and mid-cap indices are up 13.9 and 13.5 per cent over the year, respectively, while the FTSE 100 has lost 2.7 per cent, dragged down by the woes of resource companies such as Glencore (GLEN, down 72 per cent).

This divergence in performance is the single most striking feature of the investment year. It made it a good one for professional stockpickers, who easily earned their fees: the average UK equity fund is up a respectable 5.6 per cent over the year to 3 December. But there's no good reason to believe most amateur stockpickers fared any worse.

The divergence between large-caps and the rest also sets the stage for 2016. The all-too-familiar question for UK equity investors now is whether the underperformance of the FTSE 100 will reverse or continue. The answer revolves around the trio of trading assets known in investment banking as FICC - fixed income, currencies and commodities.

 

Fixed income

First up, fixed income: will 2016 be the year when the interest-rate cycle shows clear signs of having turned? Commentators obsess over the benchmark short-term rate determined by the Bank of England's monetary policy committee, which remains stuck at the all-time low of 0.5 per cent set in March 2009 - the month that can be seen as the starting point of the current bull market. But the economy is more affected by long-term interest rates, which are used to price mortgages and thus ration consumer spending. The yield on 10-year gilts reached its lowest point for decades in January. It has since risen slightly, but at the time of writing remained below its level 12 months before. The UK economy has continued to recover from the financial crisis, but the resulting upward pressure on bond yields has been offset by deflationary pressures from abroad.

 

 

A clear upward drift in longer-term bond yields would weigh on stocks in the more debt-reliant consumer sectors that dominate the FTSE 250. That said, a further drift in the opposite direction - into deflation - would also spell trouble. "The big risk next year is that deflation percolates into mainstream investor thinking," says Jeremy Batstone-Carr, chief economist and strategist at stockbroker Charles Stanley. He interprets the correction in stock values seen in August and September as a foreshadowing of this risk. Europe has long feared "hordes from the East", he points out; now the fear is of deflationary hordes of cheap products as China allows its currency to fall further and subsidises excess industrial capacity to maintain jobs.

It is sensible to remain wary of these risks, but my base assumption would still be a 'soft landing'. Mark Carney, governor of the Bank of England, has repeatedly promised the most gradual of returns to more historically normal interest rates. The ideal scenario is that this process of normalisation would increase the cost of debt for consumers and companies in line with rising wages and sales - leaving modest growth in disposable income and profits. The reality may fall short of this ideal, but I see no reason to expect either a deflationary spiral or a reflationary spike requiring radical monetary treatment.

 

Currency

It is harder to be optimistic on currency. The strong pound, particularly against the euro, hit earnings in 2015, making "currency headwinds" a tediously repetitive refrain of recent result seasons. Any weakening of the pound would therefore be very helpful, particularly for the more international large-cap index, possibly sparking a reversal in the recent trend of underperformance. But there is little obvious prospect of this in the short term. The European Central Bank in December decided to continue with its quantitative easing programme and cut its benchmark interest rate further. The measures underwhelmed the market on the day, but still seem inconsistent with a strengthening euro.

 

It all hinges on what happens to commodities

Finally, much will depend on the commodity cycle. Most commentators remain bearish on the mining and energy sectors, which are both plagued by enduring problems of oversupply. There is an obvious contrarian call to be made by buying shares in BP (BP.) or BHP Billiton (BLT) at current levels - and one day this contrarian call will surely prove profitable. But guessing the bottom is a messy business.

One worry in the commodities sector concerns dividend cover - the level of breathing space companies keep between cash payments to investors and the profits that pay for them. At the time of writing, shares in Shell (RDSB) yielded an enormous 7.7 per cent. Chief executive Ben van Beurden has claimed repeatedly this year that the dividend is not just sustainable but sacrosanct, and last month fronted an update with the reassuring claim that operating cash flows for the year to the third quarter covered both net investments and dividends. The problem is that the oil price over that year averaged $60 per barrel, whereas a barrel now changes hands for just $43.

Shell is an extreme example, but falling profits in a whole range of industries have made dividend cover a wider problem. Consider the key valuation metrics. The forecast yield for the FTSE 100 next year is 4.2 per cent, suggesting it is undervalued. But the forward earnings multiple is a rather full 15, suggesting the opposite. The simple truth is that the profits of Britain's largest companies have been depressed by weak commodity prices, the strong pound and slowing growth in international markets. Some - including Tesco (TSCO), Serco (SRP), Glencore (GLEN), Drax (DRX), Centrica (CNA), Standard Chartered (STAN), Amec (AMEC) and most recently Anglo American (AAL) - have cut their payouts, but others, like Shell, have kept them up in the hope that things can only get better.

Two pieces of good news can be salvaged from this dispiriting picture. The first, which applies above all to the FTSE 100, is that expectations are lower than they have been for years: according to Barclays, consensus forecasts for earnings growth in 2016 currently stand at just 5 per cent - far lower than at the same point in previous years. There could be substantial upgrades if conditions in commodity markets improve or sterling takes a dive. The second is that, with real wages rising and an interest-rate shock unlikely, Britain's consumer economy will probably continue to outperform. It's hardly a contrarian position, but my best guess is that UK stock investors should buy British for yet another year.