UK equities: what’s in store for 2022?

We believe the outlook for UK equities in 2022 is particularly positive – both in absolute terms and relative to other global equity markets.

• UK earnings estimates do not yet fully reflect the realities of the UK and global economic recovery from the pandemic.
• Valuation multiples in the UK are significantly lower than international peers.
• The pandemic has further forced companies to focus on cash flows, and a good number of UK companies are now emerging from the crisis with cash flow return on equity at higher levels than before the pandemic. This has not yet been reflected in valuations.

Simply put, we believe that UK equities present opportunities for a catch-up trade, which valuation-focused investors like us can aim to capitalise on.

While we are optimistic about the UK market, our portfolios are what excite us the most. This excitement comes from our positioning in high quality, cash-generative businesses, with strong liquidity, that we think are likely to emerge from the pandemic in an even better competitive position than beforehand.

Opportunity underpinned by earnings momentum

While many global equity markets are trading at elevated ratings in anticipation of an earnings recovery post-pandemic, the UK continues to trade at a discount.

The valuation opportunity in the UK is further underlined by superior earnings momentum. The recovery in forward-looking earnings estimates for listed companies since the depths of the pandemic in 2020 is significantly stronger in the UK than in either the US or continental Europe.

Between 30 June 2020 and 27 October 2021 (the time of writing), twelve-month earnings estimates for the FTSE All-Share Index have risen by +50%. Over the same period, the index’s total return has been +27%.

By way of comparison, the corresponding increase in earnings estimates for the S&P 500 has been +45% with a total return of +51%. Meanwhile, the MSCI Europe ex-UK saw an increase of +44% with a total return of +36%.

We believe this trend of superior UK earnings momentum is set to continue into 2022, against a backdrop of UK and global GDP growth.

A lot of cash in copper?

Nowhere is the case around improved cash flows more clearly exemplified than in the mining sector and in companies exposed to copper, such as Glencore, which is held in our income and value-oriented portfolios.

Copper prices are clearly elevated, and it is hard to say how long this will persist. However, the cash generation from copper producers is currently prodigious. Indeed, consensus estimates of Glencore FCF yield for the next 12 months are around 18%. 

Let’s extend the analysis for the Glencore example to look at the returns on capital implied by share prices. Not only are the implied returns less than half of current consensus estimates; they are also lower than the actual returns achieved over the past five years, when copper prices were much lower.

The ‘voting machine’ may indicate scepticism at the moment, but we will look to the ‘weighing machine’ to judge the cash returns.

Inflation and long-term structural changes: a different decade ahead?

A frequently heard criticism of the UK market is that it has little exposure to tech. 

While this is true, it does have exposure to many good companies in other areas. Often, these companies have not been strong capital growers over the past ten years. However, with the global macro situation as it is, and with inflation re-emerging, the next ten could look quite different.

Markets had got used to the idea that inflation was a thing of the past. However, what started with rising commodity prices has now spread to supply chain disruption and, crucially, to wage inflation. 

Against this backdrop, large caps are more likely to have the market power and balance sheet strength needed to offset the effects of inflation. In addition, the FTSE100 looks more like a value portfolio than the mid-250.

It is worth remembering that equities in general are a hedge on inflation, and a number of our portfolios have good exposure to utilities, which often have explicit index-linking in their business models. 

Higher inflation also tends to result in a higher cost of capital and more plentiful nominal growth. Both these factors would put pressure on high value stocks held in momentum-type strategies and favour shorter duration stocks in strategies that emphasise a fundamental approach to valuation.

Within UK equities, there is also the opportunity to invest in a good range of long-term structural themes, such as climate change and digitalisation. Utilities are a play on the energy transition and, ultimately, so are the oil stocks.

Banks and insurance companies have spent the past ten years digitalising their processes, but to pick up again on the mining theme, you can’t digitalise away a tonne of copper! Our brave new connected, digitised, electrified world will be made out of it.

Why we’re excited about our portfolios

While the medium to long-term outlook for UK equities is positive, inevitably there will be near-term volatility. 

The removal of the Universal Credit top-up, higher taxes, higher utility bills and general inflation will weigh on the UK consumer over the next year, although a large part of this pressure is likely to be mitigated by wage inflation. 

In addition, the UK savings ratio remains elevated. We would expect this to fall back, and this should support consumers’ ability to spend.

But the bottom line is that the improvement in outlook for UK corporate earnings and both the UK and global economies should, in an undervalued market, boost the outlook for UK listed equities. Key beneficiaries will likely include high quality businesses, which form a significant part of our portfolios.

This last point is key. While we are optimistic about the UK market, it is worth reiterating that our portfolios are what excite us the most. 

This excitement comes from our positioning in high quality, cash-generative businesses, with strong liquidity, that we think are likely to emerge from the pandemic in an even better competitive position than beforehand.