2021: The road to recovery for UK equities

We are optimistic at the prospects for UK equities in 2021 as the UK, and also the global economies continue to recover from the huge dislocations caused by the Covid-19 pandemic.

Already coming into 2020, UK equities had markedly underperformed global equities, since as far back as the EU referendum in June 2016. Initial uncertainties in the aftermath of the referendum were then compounded in subsequent periods by UK domestic politics, and by ongoing failure to agree with the EU on lasting arrangements post Brexit.

The impact in 2020 of the Covid-19 pandemic on global equity markets has been disproportionately felt in the UK. Although the impact of the pandemic on the UK economy is  likely to be broadly similar to that felt in other European countries, the increased risks to UK-listed businesses, as perceived by global investors with an already low appetite for UK country risk, has resulted in further marked underperformance by UK equities in 2020. At the time of writing, the FTSE All-share Index has lost 21% year to date, compared to a loss of 13% for the MSCI Europe, and a gain of 8.6% on the S&P 500 (source: Bloomberg, as at 9 November 2020).

The valuation of UK equities relative to both US and European Equities is compelling. The cyclically adjusted PE of the UK market stands at just 10.2x earnings, compared to 12.5x for the Eurozone, and 27.5x for the US. Looking at a blend of PE, EV/EBITDA, and price to Book , the UK trades at a 0.6x standard deviation discount to its own 20 year average (even at current trough earnings) compared to the US which stands at a 2.0x standard deviation premium to its own 20 year average. The relative cheapness of the UK market is widespread, with UK valuations being lower than the US in 9 out of the 10 key sectors (source: Refinitive, Panmure Gordon, as at 31 October 2020).

The antipathy towards UK equities should further be seen in the light of the geographical mix of business – only around 28% of the revenues of companies in the FTSE All-share index is actually derived from the UK. It follows that the UK market can therefore reasonably be regarded as the value play on global equities.

Whilst we expect a significant rebound in the economy and for UK listed businesses in 2021, the pathway to recovery for both is likely to remain volatile.

The impact of Brexit remains for the time being a further residual uncertainty. Our central case is that pragmatics will overcome dogmatics and that an agreement on trade, fisheries, and over the Northern Ireland border will be reached with the EU by the end of 2020. Agreement (almost in whatever form) will in our view presage a strengthening of sterling relative to the euro which may act as a further catalyst to the UK being seen as once again “investible”.

Newsflow relating to the availability of a Covid-19 vaccine will continue to cause short-term shifts in sentiment, however the optimism is also likely to be tempered by waves of reported infection, and by local restrictions, until a vaccine becomes widely available, and fear among the general public subsides.

UK government job support, and business support schemes have also provided short-term shelter that will ultimately need to be withdrawn. Unemployment in the UK remains low by historical standards at just over 4% although we expect this to rise appreciably once the support schemes are eventually phased out.

But the residual challenges in the UK resonate with similar challenges in other developed Western economies, surrounding: a levelling up of geographical and social imbalances, the need for housing, and also improvement in productivity. The cost of Covid-19 in terms of the human tragedy as well as the economic cost of disruption will take years to be fully appreciated, however it is already clear that the crisis has also acted as a catalyst to accelerate change in the global economies and also businesses that would have taken place anyway, but over a longer time frame. In this climate of change, we expect that ESG factors will be increasingly recognised as an important driver of long-term, sustainable, value creation.

Almost without exception, governments of all political colours have been moved to increase substantially the level of fiscal stimulus alongside accommodative monetary policy. The “Great Reflation” as it may well become known is, we expect, ultimately likely to result in inflation and a gradual steepening of interest rates at the long end of the curve.

In such an environment we expect commodity plays – including gold miners – to be notable beneficiaries, as well as a number of companies that offer high quality “value” exposure. A reflationary environment is likely to increasingly favour shorter duration value styles over the promise (or hope?) of long-term growth. In our opinion our UK Equity portfolios are well positioned in businesses with strong balance sheets, that are cash generative, have access to sufficient liquidity, and that we believe will emerge from the pandemic with their competitive position enhanced.

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