The UK down, but not out
08 Jul 2010
With investor sentiment dominated by overseas issues, Richard Buxton, Head of UK Equities at Schroders, gives TQ Invest his thoughts on the UK economy and the UK stockmarket in light of some historic recent developments.
In the past few months, the UK has elected its first coalition government since the Second World War; the first Liberal-Conservative coalition since the 1930s; and introduced an emergency budget to tackle one of the worst financial deficits in the developed world. Yet, with everything else going on overseas, these historic developments have been pretty much a non-event as far as the equity market is concerned. Of course, much of this comes back to the perennial argument that the performance of the UK stockmarket has limited correlation with the domestic economy - indeed, with the majority of earnings of UK quoted companies derived from overseas, what happens in China or the US remains a vital consideration. Nevertheless, there have been some significant developments in the UK over the past few months and, with some high quality, UK-focused businesses trading on very distressed valuations, it would seem sensible to take note.
Good election result; good budget
Given the severity of the austerity measures needed and the widespread nature of their impact, we believe the shape of the elected government - with a large majority and accountability residing with two parties rather than one - is a definite positive.
Furthermore, the announced budget (despite the absence of harsh detail until the autumn) appears to be a good one. Much as we expected, the new government seems to have recognised both the enormity of the problem, and the need for the UK to grow its way out. The lower-than-expected levy on the banking sector is positive, and the announced reduction in corporation tax is a good example of the kind of business-friendly policies that we expect to see from this coalition going forward.
Private sector growth versus public sector retrenchment
The success of such growth-creation measures and, specifically, the ability of private sector growth to counteract public sector retrenchment, will be the key for the next couple of years. Reassuringly, the historical precedent for this trend is encouraging.
It has tended to be the case that periods in which the public sector has diminished as a percentage of GDP have seen increased productivity growth - an area where Britain has lagged in recent years as the public sector has grown. Shrinking the government sector can open up opportunities for the private and voluntary sectors (as companies step in to fill the voids), resulting in overall job creation. During the UK's last major fiscal squeeze (between 1992 and 1996), around 600,000 public sector jobs were lost, but around 1.8 million private sector jobs were created. Coincidentally or not, an estimate of 600,000 public sector job losses over the next five years was recently leaked. While it is not possible to apply the same growth expectations this time around - with a much more sluggish picture on the cards - we believe this trend does provide some reassurance about the private sector's ability to offset the public sector pain. In fact, with some signs already coming through that private sector unemployment may have peaked, we are pretty hopeful about UK employment patterns over the next couple of years.
Corporate sector in pretty good shape
Another positive is the evidence of a healthy corporate sector before the government cuts kick in. Company balance sheets have been repaired (as a result of capital raisings and rapid and effective cost-cutting), such that recent profits growth has been strong, earnings forecasts have risen significantly and valuations, given the recent reversal in sentiment, have become increasingly attractive. In many cases, companies are also sitting on excess cash - a source of future investment, share buybacks or takeover activity. Put all those things in the context of an extremely benign interest rate environment - where rates are set to remain at historically low levels for an extended period - and the outlook for corporate sector growth seems good. With that in mind, we expect the UK economy to remain sluggish throughout 2010 and 2011, with a likely mix of slightly positive and slightly negative quarters resulting in broadly flat GDP growth overall. Crucially, we are not expecting the economy to simply roll over into a double-dip recession or, in other words, enter an extended period of significant contraction.
Wider considerations
As mentioned early on, however, the wider macro considerations of eurozone sovereign debt, Chinese growth and US economic momentum remain the key drivers of investor sentiment - particularly given the current vacuum of corporate news. That said, the US reporting season is set to start again soon, with UK corporates announcing in August. It is our belief that both seasons will be supportive of the recovery theme, but the ‘battle of the data: macro versus corporate' is going to persist nevertheless. This expectation reflects the fact that markets are likely to continue pushing the ECB into more drastic action in terms of asset purchases and liquidity provision, and that the macro data is bound to start disappointing. Indeed, we've now reached the stage at which annualised data points will be rolling over, giving rise to less dramatic signs of recovery than we have recently been seeing, and further cause for the bears to worry. We remain relatively sanguine about the outlook for global growth, however, with China seeming perfectly capable of engineering a ‘soft landing' - just as it has in previous cycles - and fundamental signs of recovery within the US housing market. Thus, while the rate of economic improvement may become more modest over the next few months, we are expecting the overall pick-up in global activity to persist.
No shortage of opportunities in UK equities
As far as stock opportunities are concerned, we feel this environment is presenting investors with plenty. On the one hand, there are a number of attractively priced, high quality companies listed in the UK that are benefiting from their geographical positioning - names like Xstrata, Charter and Burberry, which are all exposed to emerging market growth. Equally, though, we believe the market's moves to write off UK consumer-related names leaves some great value for the taking - names like Next and Home Retail Group, for example, where the management teams, balance sheets and business models are sound, but share prices discount an extremely harsh outlook on a three-year view.
Have patience
Last, but by no means least, it is worth reiterating that interest rates are unlikely to exceed 2% throughout the whole of 2011. This is a rate that, in all probability, is going to be negative in real terms, effectively costing investors to keep their money in cash. Yet, with many sound equity investments offering yields of 2%, 3%, 4% or even more, aren't investors being well-compensated to stick with shares? It's clearly going to be an eventful summer, but that doesn't mean you should turn your back on stocks.
The views and opinions in this article are those of Richard Buxton, Head of UK Equities, and may not necessarily represent views expressed or reflected in other Schroders, or TQ Invest, communications.
