Mike Felton, manager of the M&G UK Growth fund, looks back at an encouraging year for equities and explores what might be next in store for investors in the home market.
We have been advocating the case for UK equities for about a year now, suggesting a conspicuous shift in monetary policy would engender an improving domestic macro environment.
We contended that early rhetoric from incoming governor Mark Carney signalled a more proactive stance from the Bank of England (BoE), shifting from a narrow focus on inflation to a broader growth agenda.
This, we argued, would be achieved in part by the introduction of a new target measure of economic expansion, the aim being to persuade households and businesses, consumers and investors that interest rates would remain lower for longer, giving them the confidence to spend and invest.
Home team: What's in store for UK investors
A year later, it appears the new policy has worked. With growing evidence that all main sectors of the economy are trending higher, confidence has grown that the UK is squarely on the path of sustainable economic improvement. In the words of Carney: “For the first time in a long time, you do not have to be an optimist to see the glass is half full.”
In gathering evidence to support the case for UK equities, we also made the distressing observation that the government’s re-election campaign had kicked-off early.
While initially somewhat cynical about the two ‘Help to Buy’ schemes and their indubitable vote-friendly nature, we have been persuaded that rising house prices can have a broader positive impact on the nation’s economy, particularly through the influence they have been shown to exert on SME managers’ confidence.
Since these schemes were announced, the political temperature has been raised further by tit-for-tat policy announcements. Ed Miliband’s promise to freeze household energy prices certainly succeeded in grabbing the headlines but also had the effect of instantly raising the cost of capital in the sector, dealing a further blow to much-needed investment in this critical area.
At a time when the US economy will be reaping valuable competitive advantage from a shale-gas driven low cost of energy, the UK consumer and manufacturer is destined to suffer energy prices moving stubbornly higher.
Alongside similarly ill-informed politicking around EU membership, Scottish independence and transport, it appears the UK economy is improving despite – not because of – the work of politicians.
Recent events in the US remind us that poor politics is not a uniquely British vice. The desperate game of brinkmanship recently played out on Capitol Hill, that resulted in the government of the world’s largest economy shutting down and the country coming close to defaulting, would be farcical were it not so alarming.
Bizarrely though, in this topsy-turvy economic world in which we live, bad economic news is seen as good news for equity markets, as the negative impact Washington’s shenanigans have had on growth has had the effect of further delaying the Federal Reserve from tapering its massive quantitative easing (QE) programme.
This is the single biggest issue markets have to wrestle with at the moment; the elephant in the room. Unfortunately, history provides zero steer as to what happens next because the experiment being conducted by the Fed and BoE has never really been done before.
There is no precedent. We do know, however, that when QE1 and QE2 came to an end, equity markets did not respond well and they certainly suffered a serious wobble early in the summer just on talk of tapering QE3.
The job of a central banker is not an easy one, having to make forward-looking judgements on backward-looking data. While the Fed and BoE continue to keep their foot to the floor on monetary policy, the stance so far adopted by markets has been ‘don’t fight the Fed’.
In an environment of excess liquidity, capital is prone to be invested higher up the risk curve, in riskier equities and emerging markets. When the tide of liquidity goes out, however, this will likely expose those areas where the fundamentals do not justify the valuations they have been afforded.
The widespread issue here is that, while markets in the West have been drifting higher, this is predominantly as a result of a re-rating as opposed to an improvement in underlying financial strength: the P in P/E ratio has risen, the E has not.
This cannot continue indefinitely. And while equities still look undeniably attractive relative to bonds, the broad near-term opportunity we observed in the UK market at the beginning of the year has arguably diminished as it has become a more consensus view.
While macro tailwinds should continue to blow into next year, companies will have to work harder to deliver on investors’ higher expectations. Against this backdrop, firms that have been less obvious beneficiaries of the UK domestic economic recovery not only offer greater scope for future returns but should also be less vulnerable should politicians conspire to snatch economic defeat from the jaws of victory.
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