InvestmentsApr 22 2014

News analysis: Can equities keep pace with UK growth?

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The recent spate of positive economic updates, coupled with strong investment returns, have encouraged thousands to pile into UK equities.

But the UK recovery still has hurdles to overcome, and investors need to prepare for a more muted performance, industry commentators say.

Last year saw the UK achieve economic growth of 1.9 per cent, its strongest rate since 2007, and the equity market’s performance echoed the economic rebound, with the FTSE 100 index delivering a total return of 19 per cent.

Investors keen to get in on the action have been ploughing cash into UK shares. In its latest count, the IMA found that in February, UK equity funds were the best-selling sector for the fourth consecutive month, amassing net retail inflows of £555m – well above their annual monthly average of £315m.

The pace of the fiscal recovery appears to be accelerating, and the UK has been spoilt with a plethora of positive news coming through, including improving manufacturing numbers, a marked rise in car sales and a reinvigorated property market.

On the back of this, the International Monetary Fund (IMF) recently revised its economic forecasts, predicting the UK economy would be the fastest-growing G7 nation in 2014. The country is forecast to grow 2.9 per cent this year, up from a January IMF estimate of 2.4 per cent. Next year the IMF expects the UK’s economy to expand by 2.5 per cent.

But while the recovery looks to be underpinned by an increasingly broad set of drivers, there are serious obstacles yet to be overcome. Recent market returns have also highlighted the well-known lack of correlation between markets and economies, with the FTSE 100 index down by 2 per cent year-to-date.

Given the current backdrop, F&C Investments’ co-head of multi-manager Gary Potter is now neutral on equities. He says: “We had been overweight shares, but we view the market as being in a holding pattern right now. We still need to see more profitability coming through.”

Even the IMF has moved to temper its outlook on the UK. The organisation’s chief executive Christine Lagarde has cautioned that the country remains too dependent on consumer spending, and needs to see better exports and business investment.

James McCann, UK and European economist at Standard Life Investments, points out that the market has yet to see a full-blown recovery in credit creation in the financial sector – where outstanding bank lending is some 20 per cent below 2008 levels and continues to decline.

He adds: “While deleveraging has helped ease some of the imbalances built up before the financial crisis, a resumption of the credit channel is an important ingredient for a sustainable recovery.

“Indeed, there have been concerns that financial sector friction has harmed the reallocation of capital towards more productive firms and sectors since the crisis.”

However, Mr McCann points out signs that credit conditions are loosening in the UK, alongside a pick-up in demand. “While this has pricked familiar fears over household borrowing, it provides grounds for optimism over the outlook for business investment,” he adds.

JPMorgan Asset Management’s global market strategist Kerry Craig believes the IMF’s upgraded forecast has not told the market anything it did not already know.

He says: “The market is much more expensive than it was 18 months ago. The landscape has shifted, and it is the same case for both Europe and the US.”

Mr Craig warns that investors should not be holding out for a rerun of last year’s returns from UK equities, adding: “We are not going to see the same double-digit returns as we did last year – 2014 will not be a repeat of 2013.

“Investors need to be more discerning and realise there may be better opportunities elsewhere. We are more likely to see high single-digit returns. We would be very worried if we had that sort of performance two years in a row, it would be too optimistic.”

At the end of 2013 advisers told Investment Adviser they were seeking to temper their clients’ expectations of returns for this year after a stellar 12 months of performance.

Given the past five years have seen the FTSE 250 soar by 161 per cent, against 97 per cent for the FTSE 100, the robust returns have been primarily driven by domestically focused midcap stocks.

“It is like two separate markets,” says Seven Investment Management’s Ben Kumar. “The risk now is that all the good news is priced into the market.”

As a result of the disparity between the two markets, many fund managers are edging once again towards large caps.

“Many blue-chip businesses with emerging market exposure, such as tobacco firms, have underperformed, and resources have endured a torrid time,” asserts F&C’s Mr Potter.

He adds: “The mid-caps have a much greater domestic bias, and the recent outperformance of the sector is because they fell to very low levels during the crisis. I expect a much more even race and playing field between mid caps and large caps in future.”

Mr Kumar adds: “If emerging markets and especially China pick up, we could well see the blue-chip industrial and materials firms in the FTSE 100 do very well.”