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No bias like home

Dave Baxter examines what clarity over the end of the pandemic and Brexit could bring for the UK market
No bias like home
  • The Covid-19 pandemic has forced most people to stay put
  • The opposite rings true for our investments

Kitchen tables, desks and beds. While many elements of 2020 will eventually fade from the collective memory, few of us will quickly forget just how much time we have spent working, eating – and living our lives – in the same confined space. From months spent labouring at a kitchen table to ‘staycations’ and even the dreaded Zoom party, the Covid-19 pandemic has forced most people to simply stay put.

But if few have left home shores or even their neighbourhoods that much since March, the opposite rings true for our investments. UK investors have long been fond of overseas stocks and funds, with any home bias that once lingered in portfolios rapidly receding in recent years (see right chart below). The year 2020 is likely to have accelerated this: the pandemic has seen investors ditch a market that, having been dogged by Brexit uncertainty, then found its biggest industries on the wrong side of many lockdown trends (see chart).

On the bright side this means domestic shares are still extremely cheap. As our guest columnists Gina and Alan Miller note, large UK companies recently traded on enormous discounts to their overseas counterparts – and by the Millers’ account not all of this can be explained by the UK’s heavy exposure to troubled sectors such as oil and gas. 

As November’s fierce rally demonstrates, there is significant upside to be found whenever UK stocks get a whiff of clarity. The question is whether we are due any more good news, and what the future holds. Home bias may already be on the retreat, but is it time for a fightback?

 

 

The upside

Given the huge, vaccine-led gains made in beaten-up UK sectors in November, it is first worth outlining the case for optimism. Much of this rests on the idea that UK equity valuations are based mainly on bad news, from the difficulties of some of the market’s major sectors to a chaotic pandemic and various Brexit unknowns.

If little but bad news is in the price, any glimmer of certainty could push UK returns further into the black. The arrival of a vaccine suggests that British business activity will resume, to some extent, in 2021. The economic outlook should improve as businesses go ahead with investment plans once put on the backburner and consumers forced to save by sporadic lockdowns now splash the cash.

As for Brexit, even an imperfect outcome would provide greater clarity and potentially draw investors back into the market. The huge share price gains that accompanied 2019’s general election result suggest that any hint of an outcome could trigger further wins.

The UK retains two elements of appeal. From a business perspective it maintains many traditional operational advantages, from the universal language of business to an entrepreneurial spirit and strong legal and accounting standards. Keith Ashworth-Lord, manager of CFP SDL UK Buffettology (GB00BKJ9C676) and an unsurprising evangelist, believes this makes the UK “second only to the US” as a business location. In his view, recent negative sentiment presents a good opportunity for the patient investor.

Secondly, dividend yields should continue to support the market to some extent. Even after a year of severe cuts, the UK stands out as a higher-yielding alternative to other major equity regions, and a dividend recovery of sorts is in the making.

In its UK Dividend Monitor report covering the third quarter of 2020, Link Group announced that the “worst is over”. Link predicts that the UK market will yield between 3.3 and 3.6 per cent in the 12 months from the end of Q3 2020. Few overseas markets offer comparable yields.

 

 

Not so fast

One problem is that even if the UK has been underpriced, few have been willing to choose it over the alternatives. US and Asian markets have performed strongly this year, and the likes of big tech have capitalised on trends that accelerated in lockdown and should persist to some extent, even when economies reopen. The UK, by contrast, has little exposure to some of the new world trends. The market composition may also put it on the wrong side of the clamour for ESG investing.

Charles Younes, research manager at FE Investment, argues that this structural problem remains hard to ignore. His team halved the UK allocation in their investment portfolios over the summer, and the rally of November has not changed any minds. “If you look at the prospect for UK companies it’s becoming darker and darker even if you remove the Brexit risk,” he says. “If you look at the composition of the FTSE, it’s not rightly positioned to face the structural change in the post-Covid world.”

He, and others, are not convinced that a quick economic rebound is definitely on the cards. The format and impact of any economic reopening is unknown, and many consumers and businesses will leave the pandemic in a weaker state than they entered it. “Some companies have to repay debt or government money,” says Mr Younes. “Some companies have simply closed, like Debenhams.”

Scepticism can also apply to hopes of an extended market rally. Too much good news could now be in the price, and the past decade has demonstrated that value rallies can be notoriously short-lived.

While some may want to take a punt on cyclical exposure or a broader rebound for UK stocks, remaining picky may be key. A look at names such as the Buffettology fund suggests that building a concentrated portfolio of strong companies is one way to ride the ups and downs of the domestic market. Chris Beauchamp, chief market analyst at IG, points to “pockets of good companies” listed in the UK that have international exposure and could benefit from a global reopening, from Diageo (DGE) to Compass (CPG). In hindsight, investors had the chance to buy the latter at a five-year low in March. He also points to the UK’s leading pharma names, which have performed solidly in the crisis.

An active approach, from picking a stock to buying funds, may be the best way in. Richard Staveley, manager of the Gresham House Strategic (GHS) investment trust, does present an optimistic case for the UK but believes that performance dispersion between different sectors will persist as the economy reopens.