Reversal of fortunes, Brexit and dividends: The outlook for UK equities in 2021

Trevor Green, UK equity portfolio manager at Aviva Investors, picks three themes that could have a big say in how the asset class performs in 2021.

Reversal of underperformance, Brexit and dividends: The outlook for UK equities in 2021

1. UK equities badly underperformed most other developed markets in 2020, leaving many shares looking cheap relative to international peers. Should the global economic recovery accelerate in 2021, this trend should begin to reverse.

The UK market has struggled relative to other equity markets since the outcome of the European referendum of 2016. That trend accelerated last year due to the high weighting of financials and oil and gas producers, and the comparative absence of big technology companies.

This has left UK shares looking cheap based on several yardsticks, such as price-to-earnings ratios, price-to-book values and dividend yields. This is reflected in the fact rolling-three-week returns from investing in UK equities are currently more highly correlated to the MSCI Value index than at any time in the past three decades.

There is reason to believe the recent pick-up in global economic activity will persist into next year

With vaccines to protect against coronavirus now being rolled out, there is reason to believe the recent pick-up in global economic activity will persist into next year. This should be of particular benefit to the UK market, given value stocks tend to outperform the wider market during the early phase of economic recoveries.

2. The shadow of Brexit has loomed large for the past three and a half years. While the country may be heading for what would once have been considered an extremely damaging ‘hard’ Brexit, the mere fact uncertainty is about to be lifted could provide the stock market with a positive jolt.

There seems little doubt the UK economy is going to be damaged as the country’s transition agreement expires at the end of December. It might seem strange then to suggest the conclusion of the protracted Brexit negotiations could be taken positively by the stock market.

As the uncertainty begins to lift, companies will start to adjust to their new reality out of necessity

It has been apparent for some time the UK was heading for a hard Brexit. Consequently, much of the bad news has already been priced in. As the uncertainty begins to lift, companies will start to adjust to their new reality out of necessity. Capital expenditure that has been long delayed could gradually start to pick up.

Perhaps most significantly, mergers and acquisitions, having been stifled by the uncertainty created by Brexit, could start to proliferate. Insurer RSA and gambling group William Hill both recently agreed to be bought. With private equity investors sitting on record piles of cash, and funding costs at a record low, others could follow. After all, relative to other markets, UK equity valuations are offering the kind of discount that only comes around once a decade or so

3. UK dividends are forecast to fall by as much as a quarter in 2020. Should economic growth return in 2021, there is every chance company payouts will rebound strongly.

Dividends are set to fall more sharply in the UK in 2020 than elsewhere thanks to the heavy weighting in UK indices of financial and oil and gas stocks. Whereas companies in both sectors usually tend to pay attractive dividends, that was not the case in 2020. Banks and insurers were pressured from doing so by their regulator, while oil producers were hit by a collapse in crude prices.

The market looks to be underestimating the potential pace of the recovery in dividends

Many companies have already resumed dividend payments. With banks now permitted to resume dividends by the regulator, there is a strong possibility some companies will make special payments to shareholders as a means of recompensing them for the dividends they forfeited in 2020. The market looks to be underestimating the potential pace of the recovery in dividends.

The UK market has historically offered an attractive dividend yield relative to other developed markets, most notably the US. Should dividends recover faster in the UK than elsewhere, the yield on stocks could prove alluring to investors starved of income.

In summary

While there may be good reasons to expect a decent performance by UK equities in 2021, it is worth bearing in mind the market has already risen sharply following the development of effective coronavirus vaccines.

Share prices have surged in recent weeks, reflecting the market’s belief there will be a strong recovery in economic activity in 2021. It remains to be seen how quickly unemployment rises as the government’s furlough scheme ends next March and what impact this has on consumer spending. The speed and scale of the rally means there is limited room for disappointment.

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