Will UK equities get their mojo back in the 2020s?

Unstable politics and Brexit played a key role in what was a difficult decade for those investing in the UK in the 2010s.

Both leading UK stock market indexes markedly underperformed global stock markets: the MSCI World index returned (201.2%)^ compared with 104%^ for the FTSE 100 and 118.3%^ for the FTSE All Share. UK growth (GDP) did not fare well either, averaging 1.3% across the decade*, with no growth whatsoever recorded in the final quarter of 2019**.

The buying power of sterling was also hit – at the start of the decade a pound would buy you 1.62 US dollars, by the end it was 1.32*.

A recent note from Fidelity points out that the biggest ‘theft’ of the decade was time – pointing to the fact the last four years were dominated by Brexit*. Since June 2016, it has been a cloud over the economy which meant the government, households and corporates were on perennial standby as we awaited the outcome. During that time, foreign investors stayed firmly on the sidelines as uncertainty made UK companies distinctly unattractive.

However, have the last few weeks of 2019 given us cause for optimism in 2020? Prime Minister Boris Johnson’s success in the General Election should give us stable politics for the next few years, and hopefully deliver some clarity on Brexit sooner rather than later.

Will the UK recover after leaving the EU?

On 31 January 2020, the UK finally left the European Union. We have moved into a transition phase where we will seek to forge new relationships and tackle issues around trade with the EU.

As Schroders senior economist and strategist Azad Zangana points out, 2019 was a particularly challenging one with the UK on the verge of recession***.

He says: “With best efforts being made to prepare for the worst possible outcome, the risk of a sudden stop to trade and possible shortages of goods was a real danger. It still is. In the absence of a trade agreement or an extension to the transition deal, the UK could be facing the same no-deal or cliff-edge Brexit at the start of 2021.”

Zangana believes once discussions over EU common standards are addressed (namely what they are and what happens if you break them) the conversation will turn to a sectoral approach to trade, believing this – rather than an “all or nothing approach” – reduces the chances of a no-deal outcome. He says the UK is likely to favour the manufacturing sectors, like the auto industry, chemicals and machinery, over services, due to the complexity and lack of time for negotiations.

He says: “Sectors that are excluded are likely to face tariffs, but they may be compensated by the government. The UK might push for a new transition agreement for these sectors to limit the impact on businesses, with a view of agreeing a “phase-two” deal to cover them.”

Are there positive signs?

Fidelity points to three particular reasons why the UK now looks like an opportunity. The first of these is valuation and sentiment. The past decade of underperformance compared with global markets – an offshoot of investors staying on the sidelines due to the uncertainty – means that UK equities are still unloved and “fairly valued to under-valued versus their own history and undervalued relative to the rest of the world”*, making the UK an attractive option.

The second rationale is the fundamental attractiveness of the UK economy in general due to our rule of law, (now) functioning democracy, good health and care system, strong governance and an independent central bank. When you compare this list of pros with the cons – like Brexit uncertainty and an ageing population – it indicates the market has treated the UK negatively by giving more weight to the near-term uncertainty and forgetting some of the long-term positives.

The third point is the long-overdue stability of Government over the next few years, following the Conservatives’ majority victory in the Christmas election.

What does growth look like in the future?

With austerity hopefully behind us, the Government will give its first strong indicator on UK growth at the Budget on 11 March 2020. This should give us an inkling of how willing it is to loosen the reigns and spend on housing, education and infrastructure, for example. Or will belts remain tight amid fears of a no-deal scenario, should discussions in the transition period with the EU go badly?

Schroder’s Zangana feels that, while the signs are positive, it will take time for the data to filter through and boost the UK economy. He says: “A significant handicap in the short-term is the build-up of inventories (or stockpiles) which took place last year to protect against a no-deal Brexit outcome. Inventory levels are now being reduced but they still remain high.

“This means the recovery in production and output could be delayed, while inventories are run down. This suggests GDP may not rebound much before the second half of the year. However, once it does, the UK should enjoy above average growth through at least 2021.”

Clarity on trade negotiations will hopefully give companies the confidence to start spending again

While the signs are positive, ultimately it will come down to the progress the UK Government makes in those phase two negotiations. As Zangana concludes: “If businesses see headlines about World Trade Organisation tariffs looming, then currency volatility will return, and businesses will retrench.”

If the Brexit cloud does lift, investors may want to consider value-focused UK vehicles, which will feel the full benefit of the recovery. These include Alastair Mundy’s Investec UK Special Situations fund, which has historically performed during turning points in investor sentiment. Others to consider would be funds focused on smaller companies, such as the Liontrust UK Micro Cap fund or the Marlborough Special Situations fund.

Those who are more pessimistic may prefer to stick to UK funds with a focus on larger companies with international-earnings. These tend to be income-yielding funds like the Rathbone Income fund, managed by Carl Stick, which has 64% of its holdings in FTSE 100 companies^^, or the Royal London UK Equity Income fund, which also has many of the largest companies listed in the UK among its top 10 holdings^^.

 

^Source: FE Analytics, total returns in sterling, 1 January 2010 to 1 January 2020.
*Source: Fidelity Insights, 10 February 2020
**Source: Office for National Statistics, October to December 2019
***Source: Schroder perspectives, 4 February 2020
****Source: Trading Economics, United Kingdom Manufacturing PMI, January 2020
^^Source: fund factsheets, 31 December 2019

The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Before you make any investment decision make sure you’re comfortable and fully understand the risks. If you invest in fund or trust make sure you know what specific risks they’re exposed to. Past performance is not a reliable guide to future returns. Remember all investments can fall in value as well as rise, so you could make a loss.