There is considerable uncertainty over the outlook for the UK economy with Brexit negotiations under way – and it is unlikely to disappear any time soon.
It is still harder than usual to foresee the path for sterling, gilts, credit, UK equities and the relative performance of different sectors and large companies relative to smaller concerns. With regards to JP Morgan Asset Management, the company continues to take a neutral approach to UK equity investing.
Indeed, UK economic data looks mixed: UK unemployment has fallen to its lowest level since 1975, to just above 4 per cent. Typically, low unemployment would speed up wage growth, but the weak pound means inflation at about 3 per cent is wiping out the 2 per cent nominal wage growth, resulting in negative real wage growth. As real wages have been shrinking, consumers have been saving less.
However, there are reasons to be optimistic.
A lower savings rate has been helpful for the economy in that retail sales and consumption in the UK held up better than they otherwise could have done just after the fall in sterling. It goes without saying that at 60 per cent consumption, the UK consumer is key for the nation’s economy. However, the dip in consumer confidence could damage more domestically orientated companies that rely on UK consumption.
The economy also continues to be supported by UK businesses. While investment intentions surveys for both manufacturing and services companies took a hit last year, they have since recovered to pre-referendum levels, with the Bank of England estimating that quarterly growth in business investment will contribute 0.5 per cent to GDP growth over the next quarter.
Large-capitalisation multinational companies listed in the UK’s FTSE 100 source nearly 70 per cent of their revenue from abroad, so when sterling falls, their stock prices tend to rally. After the UK’s referendum on EU membership in June 2016, sterling fell dramatically and the FTSE 100 rallied, providing some of the best local currency equity returns for 2016. So, if sterling rises, the more domestically focused mid and small-cap stocks should outperform.
UK equities remain a decent bet for the future, when considered against other options, but the exceptional uncertainty investors face over the next few years should counsel against taking large sector or style bets in one’s portfolio.
UK fund managers have had a large bias towards small and mid-cap UK equities over the past few years, which has paid off handsomely. In fact, the average weight of an all-cap UK equity fund to the small and mid-cap space is above 40 per cent, whereas the benchmark weight of small and mid-caps in the FTSE All Share is only about 20 per cent.
This means the average UK equity fund is about 20 per cent overweight to small and mid-caps. In this environment, it could make sense to hold a small and mid-cap weighting closer to the benchmark.
A positive for investors in UK equities is the fact that UK companies pay high dividends. UK equity dividend yields are about 4 per cent for the FTSE All Share. This is notably higher than the dividend yields on offer in the US, Japan and Europe.
It is certainly tempting to look at the global exposure inside the UK equity market and conclude that an international bias is justified within the asset class. However, although sterling may well suffer short-term sell-offs as evidence of dysfunction in the Brexit negations continues to surface, by my calculations it remains well below fair value and is likely to gradually appreciate in the decade after the negations are concluded. Any sustained appreciation would actually cause portfolios with foreign exposure to lag.
For now, sticking close to the benchmark remains the base strategy for UK equities with a preference for small to mid-cap and finding income from UK equities is a good way to dampen the volatility in potential price fluctuations.
Nandini Ramakrishnan is global market strategist of JP Morgan Asset Management
