Will the gathering UK recovery translate into returns?

Latest official statistics put GDP growth in the first quarter of 2014 at 0.8 per cent, equating to a six-year high annual growth rate of 3.1 per cent. The International Monetary Fund (IMF) and the OECD have suggested the UK will be the fastest growing G10 nation this year.

This has prompted debate about when the Bank of England is likely to raise UK interest rates, although the general consensus is it will be comfortable to wait until next year.

Stewart Robertson, senior economist at Aviva Investors, sums up the mood of optimism by highlighting that 12 months ago the country was “worried about a triple-dip recessio” and embroiled in a “fierce debate about fiscal austerity driving the UK economy back into stagnation”.

Now, he says, the economic revival is “well established”, although he also summarises a lingering complaint and concern among his peers that want to see “greater contributions from investment and exports and a little less from housing and the consumer”.

Beyond borders

So what impact will the recent economic growth have on the performance of equities in the UK?

Some would say not much. As Nick Peters, portfolio manager at Fidelity Solutions, highlights, a number of studies conclude there is no direct link between GDP growth and the performance of the market - a supposition proved by equity market performance in recent years.

He explains: “2012 illustrates that point, when the UK equity market delivered double-digit returns alongside a GDP growth close to flat.”

Having said that, Mr Peters adds: “Emerging signs of economic growth should boost corporate profitability and cash flow generation, and the impact of these will work their way through to stock valuations thereafter.”

Mr Peters also emphasises that the UK - and UK companies - are not solely defined by their home country economy, and that improving prospects further afield should be adding to any optimism being felt by investors.

“Investing in the UK market means exposure to a wide variety of countries. Around half of the business done by companies in the FTSE 100 is done overseas, so optimistic prospects for the US, Asia and emerging markets should translate to good opportunities for UK businesses and their stocks.”

By all accounts an economic recovery in the US is already underway, while investors will be hoping that a period of underperformance in emerging markets could be about to turn round.

One such indicator is the level of mergers and acquisitions activity. A recent report from Standard Life Investments claims not only that M&A is picking up in the US and beyond, but that activity will continue into next year.

The investment manager argues that increased availability of business funding, an improving economic backdrop and continued pressure on companies to reduce costs has encouraged M&A activity to start up again. It identifies that the upturn began in the US, with Europe, Asia and emerging markets now following suit.

On this basis, Standard Life Investments has a ‘heavy’ asset allocation to UK equities, citing an improvement in both the domestic economy and overseas order books which it believes are feeding through into stronger earnings growth for a wider range of companies, while valuations appear relatively attractive.

Valuation concerns

A bellweather of the UK is typically mid-cap stocks, which have traditionally have outperformed large caps.

The past 12 months has been no exception, with mid-caps up 12.9 per cent and the FTSE 100 up by just 4 per cent, according to Gervais Williams, managing director of the Miton Group and an equity portfolio manager since 1985.

However, he observes a recent shift which has seen mid-cap stocks begin to underperform. He refers to the period between March 7 2014 and May 9 2014, when the mid-cap index fell 3.9 per cent in absolute terms while the FTSE 100 was up 1.64 per cent.

Some of the recent bid activity in the FTSE 100 explains its uptick in performance, but Mr Williams says fund managers are unsure whether the performance of mid-caps is a short term trend, or something that will play out over the longer term.

So while he believes there are plenty of opportunities in UK equities as a result of some “exciting IPO activity”, he also sounds a note of caution and highlights the link between valuations and earnings as the key barometer in the coming months.

Mr Peters says he is “thrilled” with the range of opportunities and says a lot of companies around are “dead cheap”, but he also argues that the UK market is finely balanced in general pricing terms as a steady rise in valuations over the last couple of years has not been matched by earnings growth. This will need to change if valuations are not to begin to appear unattractive, he warns.

Andrew Bell, chief executive of Witan Investment Trust, also cautions that equity markets are not as cheap as they were five years ago.

He adds: “I think the process of economic convalescence is underway and the process of re-building the banking sector and rebuilding confidence on the consumer and business side is underway.

“I think there will be a following wind for equity investors but because growth is likely to remain relatively low compared to past recoveries and unevenly distributed, it’s not going to benefit all companies.”

Our top three UK equity fund picks

MFM Slater Growth fund

Mark Slater’s MFM Slater Growth fund remains a modest £98.6m in size in spite of its outperformance.

Its aim is to achieve long-term capital growth through investing in UK companies. The fund comes top for performance over the last five years in the IMA UK All Companies sector, with a return of 266.93 per cent to 11 May 2014, against a sector average of 95.52 per cent over the same period.

Schroder Recovery fund

The £586.6m Schroder Recovery fund sets out to achieve capital growth for investors by investing in UK quoted shares of companies that have “suffered a setback”.

Co-managers Kevin Murphy and Nick Kirrage have been running the fund since July 2006, although it dates back to May 1970. It is ranked top quartile in the IMA UK All Companies sector over six months, and one, three, five and 10 years. In the 10 years to 11 May 2014, the fund delivered a return of 223.69 per cent.

Neptune UK Mid Cap fund

The £154m Neptune UK Mid Cap fund is a more recent launch, with manager Mark Martin having joined Neptune in February 2008 and launched the fund the same year to invest in companies listed on the FTSE 250 as well as the top 50 companies by size in the FTSE Small Cap index.

Over five years to 11 May 2014, the fund has returned 185.39 per cent to investors and is top quartile over one, three and five years.