Chris Murphy and James Balfour, co-fund managers of our UK equity income strategy, reflect on the big shifts in 2022 and what they could mean for the asset class in 2023.
Read this article to understand:
- The trends defining UK equity markets in 2023 and beyond
- Where the risks and opportunities lie
- How energy prices, inflation and higher interest rates will impact UK equities
The long wait goes on for the return of international investor favourability to UK stocks. This isn't fully reflected in the return of the UK equity market, which is dominated by a handful of companies such as Shell (eight per cent of the market) and AstraZeneca (over seven per cent). UK stocks below the mega caps are more representative of what has been happening. The FTSE250 fell 20 per cent in 2022, while the FTSE100 was up one per cent.1
However, given the concentration in the latter, investors could benefit from greater diversification by taking exposure to selected names rather than simply following the market. Even though 2022 was a difficult year for UK equity investors, much of the sentiment has been driven by external factors like the war in Ukraine and the mini budget. It doesn't necessarily reflect the long-term prospects of listed businesses, many of which have international portfolios, even beyond the mega caps.
Following COVID-19, corporate balance sheets are in reasonable shape, and a lot of company dividends adjusted through the lockdowns, meaning large parts of the market haven’t been over-distributing income. Investors can build portfolios yielding up to five per cent, which is a good starting point for a total return investment.
Today might therefore offer an interesting starting point for investors to look at owning the UK, but near-term headwinds and uncertainty require a longer-term, three-to-five-year view.
Chris Murphy and James Balfour, co-fund managers of UK equity income at Aviva Investors, discuss what 2023 might have in store and what investors should do to avoid tunnel vision centred on the flow of bad news.
Looking at the big picture for UK equities, what could change in 2023 compared to 2022?
CM: Certain catalysts, like the war in Ukraine, and the fact it would still be raging almost a year on, are impossible to predict. This year, winter with large chunks of Ukraine without power, an energy crisis across Europe, and a global food crisis will bring more uncertainty.
On the flip side, 14 years after Lehman Brothers went bankrupt, it was more predictable the world was destined for a macroeconomic slowdown. Since the global financial crisis, we have been in a regime of free money, quantitative easing, and no inflation. That was never sustainable, and we are now going through a regime shift.
We are moving into a world where inflation and higher interest rates will be more normal
We are moving into a world where inflation and higher interest rates will be more normal, particularly given current high levels of government debt across developed economies. Overlaying this, geopolitical risk continues to rise, which could result in more onshoring, adding to reasons why we may enter a period of structurally higher inflation compared to the last 15 to 20 years.
Investors who have only ever invested in that period of low inflation and interest rates are struggling to cope with this change. That is impacting US tech stocks, for example, but also UK equities. Asset allocators need to take time to think and adjust to these new trajectories of inflation, interest rates and monetary policy.
On a positive note, the Bank of England has signalled that, once oil-price and food inflation work their way through, inflation will be coming down, so rates will probably not go as high as expected.
However, because we cannot predict what other investors will do, we do not want to take a wholesale position on whether they might take risk on again in 2023. Instead, we find unloved assets whose valuations are depressed versus global markets and should offer positive returns.
We focus on company fundamentals we believe are underappreciated by the market. This has contributed to our portfolio having more mid-cap exposure than the broader index, which we think can give investors more attractive and fundamentally driven income, income growth and capital growth.
Where do you see those opportunities?
CM: We find interesting sectors across the UK, from electrical utilities (such as National Grid, Greencoat Wind and SSE), which has structural growth drivers as we aim to electrify the UK economy from a more renewable power source, through to engineering companies – the aerospace industry is strongly rebounding – and even selectively, within retail. We have not taken much exposure to the latter yet, but it is on our horizon. Other than a few banks, financials have been hard hit, so we also see value there.
Active markets tend to be six to 12 months ahead of the real economy
JB: Active markets tend to be six to 12 months ahead of the real economy, and there has been a recovery in the last six to eight weeks, with some positivity. But signals point to a year-long recession in the UK. In this context, and because of our longer time horizon, we will happily look at companies for which things could get worse over the next six months if we like their business model and think they are ultimately going to be winners.
Currently, that is in more established firms like electrical utilities and some industrial companies, where there will be a slowdown, but that are well protected. Retail might take somewhat longer, but a lot of the sector is bouncing back from COVID, which has offered companies opportunities to increase market share.
Although investing is partly about trying to understand macro events, it is also about taking a long-term view, and looking at business models to find companies that can perform in all conditions.
Which areas could come under pressure?
CM: Almost everything is going to see downgrades, but that is the same in Europe and in the US. Companies haven't really been downgrading yet. They have been surprisingly robust compared to share price reactions.
We have been in a world where just a few businesses have driven UK stock market performance. To think the same will happen again, where a few companies representing 20 per cent of the market continue to perform, seems unlikely.
We have been in a world where just a few businesses have driven UK stock market performance
Within most sectors, there have been companies, perceived as high-quality growth businesses, that have derated from multiples over the last couple of years in an unprecedented manner. Yet, they are still on significant premiums compared to the rest of their sectors. You can see this in Halma and Spirax-Sarco Engineering.
What I find difficult to see happening is that, when investors want to take on risk again, they will want to rerate these companies even higher. We think it's more likely multiples will compress and some of the steadier return businesses will do well. We are pragmatic in terms of what we look at and applying discipline, because if interest rates don’t go back to zero, these companies should not be on such high multiples.
JB: Energy prices will also have an impact. Most companies are hedged for the next six months, but they will have to manage uncapped downside or upside in energy prices from April onwards. This creates more uncertainty for smaller businesses where it will have a bigger delta. We have already seen shops and pubs closing because they cannot afford the energy bills, so that is a downside for the beginning of 2023.
Energy prices will have an impact on smaller businesses
Larger but energy-intensive businesses like paper companies will be better able to manage in the coming months, as they can pass rising costs through to their customers. But if inflation averages between three and five per cent over three years or more, they will find it harder, because customers will start asking them to improve their productivity instead.
If we were to fast-forward a year, what will the market look like?
CM: While we cannot know what the situation will be in Ukraine, we should be in a better position with regards to the energy crisis, because supply chains around the world are working out solutions. To say definitively how much better is almost impossible, but it is interesting the oil price isn't significantly higher. It started 2022 around $70 and ended it around $85.
We all have tunnel vision about how bad everything is, but we get used to difficult situations. Conditioning to a world of higher inflation and rates should be working through, and inflation itself should have improved, although it is a function of what happens to wage inflation. We will also have been through more rate hikes and that picture should be clearer.
By this time next year, most of the downgrades will have worked through the system
In addition, by this time next year, most of the downgrades we expect to see around the developed world will have worked through the system, so it should be more positive.
But what is interesting is that, looking at the individual building blocks, companies are not seeing much of a slowdown, balance sheets are strong, and households have paid down their credit card bills.
What would be most worrying about an economic slowdown is if unemployment spiked, but UK companies, large and small, are all struggling to hire enough staff. That means employment will likely remain robust, which gives us comfort the slowdown won't be catastrophic – barring another unforeseeable spike in headline and wage inflation central banks can't control.
The key is to be as objective as possible and stand back from the headlines. Investors need to learn to cope with the regime shift, which is affecting equities everywhere – not just in the UK. It then comes back to sticking with the basics: valuations, yields, diversification, international exposure of companies and ESG.
Within this framework, the UK remains attractive, on the ESG side because the country is leading the world on the net-zero transition, and more broadly because the rule of law is still attractive to companies.