Pullback raises appeal of UK stocks

Investors have naturally started to question the outlook for stocks against a backdrop of rising bond yields, a sudden pick-up in volatility, and concerns over inflation. 

We view the recent sell-off in equity markets as a technical-driven correction, not the start of a bear market.

While the surge in volatility has undermined sentiment in the short-term, positive fundamentals remain in place and suggest equities could continue to receive support over the medium- to long-term.

Supportive factors include the ongoing synchronised global economic recovery and broad strength in corporate earnings, while concerns over a possible inflation shock also seem misplaced. 

Bond yields have risen sharply this year, but we believe they are rising for the right reasons.

Despite the recent climb higher, yields remain well below their long-term historic averages, suggesting they would need to push materially higher before threatening to derail the momentum in global stocks.

Importantly, earnings continue to improve against a strengthening global economic backdrop, factors that should be supportive for UK equities, assuming a smooth transition out of the European Union.

The yield on the benchmark 10-year US Treasury has averaged 3.7 per cent over the past 20 years, some 90 basis points above current levels.

In the UK, the average yield on the equivalent government bond over the past 20 years is more than 200 basis points above current levels.

We believe a stronger pick-up in inflation would be required to return bonds yields to their historic averages, a factor that would lessen the relative appeal of equities compared to bonds.

However, in the current environment, the risk of an inflation shock appears to be relatively contained.

Sterling strength has been a potential headwind for large-cap stocks in the UK given that more than two-thirds of the revenues generated by constituents listed on the FTSE 100 index are derived from international markets.

However, the US corporate tax cut should more than offset this. 

Importantly, earnings continue to improve against a strengthening global economic backdrop, factors that should be supportive for UK equities, assuming a smooth transition out of the European Union.

This earnings expansion supports our view that markets have simply derated in recent weeks and are not facing the prospect of an earnings collapse.

The dividend yield for the UK’s FTSE All-Share index is currently around 4.25 per cent on a 12-month forward basis, while dividend cover has also expanded over the past year.

Notwithstanding the pressure that Brexit continues to apply to the UK market, we believe that the recent pullback in equity markets presents a compelling opportunity.

UK equity valuations were already looking attractive versus history on a price-to-earnings basis before January’s sharp sell-off.

The FTSE 100 index’s near-10 per cent drop from its recent peak has only served to make UK valuations more attractive still, creating a buying opportunity for investors.

Furthermore, a dissipation of Brexit-related uncertainty - even if only a modicum - could be accompanied by a relief rally in underperforming sectors of the UK equity market.

Alan Custis is head of UK equities at Lazard Asset Management