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
Even though 2022 was a difficult year for UK equity investors, much of the negative sentiment was driven by external factors like the war in Ukraine and the Liz Truss-Kwasi Kwarteng “mini budget”, rather than the long-term prospects of listed businesses, many of which have international portfolios.
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 (CM) and James Balfour (JB), co-fund managers of UK equity income at Aviva Investors, discuss their outlook.
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.
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.
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 that 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 the UK economy transitions to more renewable power sources, 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.
Signals point to a year-long recession in the UK
JB: 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-19, which has offered companies opportunities to increase their 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 the 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.
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.
We all have tunnel vision about how bad everything is, but we get used to difficult situation
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.
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.