Have UK equity funds finally returned to favour after years in the doghouse? The latest fund flow data suggests they are on the up: retail investors put a net £532m into the space in May, meaning they outsold funds in every other equity region.
The uptick in demand could yet prove to be temporary, but the factors behind it are easy to spot. Domestic stocks have become cheap by many metrics in recent times, driven by the decision of investors to shun the region amid Brexit-induced uncertainty.
However, the UK market never really lost its appeal when it comes to another attribute favoured by investors: income. Domestic stocks have long had a propensity to yield more than equities elsewhere, and they have looked particularly attractive recently. If payouts match current forecasts, the FTSE 100 will yield 4.5 per cent this year. But a number of recent upsets in the market, combined with the absence of certainty around Brexit, means investors must be picky about their equity income strategy.
A better day
Those backing the UK market have already notched up some big victories in 2019 – including handsome capital returns. The FTSE 100 was up by 14.8 per cent for the year to July 11, with the FTSE All-Share gaining 14.3 per cent.
Funds have slightly lagged the markets but still look healthy in performance terms: the average fund in the Investment Association’s UK All Companies sector has returned 13.8 per cent, compared with 11.9 per cent from its IA UK Equity Income equivalent.
Income investors should also take comfort from the fact that dividends look well protected in some respects. UK-listed businesses are already loath to cut dividends in such a yield-hungry market, and many now look better placed to finance such payments using profits than they have in several years.
Dividend cover, or the ratio of a company’s profits to dividend payments, stood at 1.68 times for the FTSE 100 in mid-2019 – its highest level since 2014. That suggests dividend payments are built on more solid foundations than before. However, there is still room for improvement. As AJ Bell notes in its latest Dividend Dashboard analysis: “You would really like to see this ratio at 2.0 times or above, to provide a safety buffer just in case the UK did unexpectedly slip into a recession, or analysts’ forecast of 8.8 per cent growth in earnings per share for 2019 proves wildly optimistic.”
What could happen to the UK economy in future? While Brexit has muddied the waters, any sign of certainty could arguably boost markets and business conditions.
Chris Murphy, a UK equity fund manager at Aviva Investors, says: “People are waiting for Brexit to be sorted, whatever it is. I think private equity has a wall of cash and international investors have a lot of money and they will start buying UK assets [once there is certainty].”
However, the ultimate effect that Brexit may have on dividends is hard to predict, because of the impact currency fluctuations are likely to have. Any deterioration in the economy could force companies to question the viability of their current payouts, but if this economic slowdown caused sterling to fall further, that would boost companies’ non-sterling dividends and the value of their overseas earnings.