Despite the poor start to the year, investors can take heart from a number of encouraging factors, says Trevor Green.

Global stocks markets, including the UK, have experienced a ‘Nightmare after Christmas’ as weak data from China and increased tensions in the Middle East have alarmed investors. The uncertainty caused by a possible referendum on the UK’s membership of the European Union, and the prospect of the first rise in interest rates since 2007 may also unsettle investors.

Key points

  • Supportive factors include the economy, attractive valuations and strong M&A activity
  • Risks include a major slowdown in China and the possibility of higher interest rates
  • Robust consumer demand is likely to prove a key driver and we have identified a number of attractive stocks in this area
  • We also see considerable potential for higher dividends and special dividends
  • Clothing retailers enjoyed little cheer this Christmas

Reasons to be cheerful

However, there are reasons to be positive about the outlook for UK equities in 2016. The economic background remains encouraging with the UK recording the second fastest growth rate among advanced economies in 2015, while the fortunes of British consumers are also improving after the long, lean years of austerity. Further grounds for optimism include robust levels of M&A, the potential for special dividends and positive dividend surprises. Valuations also remain attractive.

Free-spending shoppers

Household discretionary incomes, as measured by the Asda Income Tracker, increased by nearly ten per cent year-on-year in October to £193 per week. This is the highest level since the global financial crisis began. Falling fuel prices were a key factor, and consumers are also benefiting from higher employment, wage growth and low inflation. The sharp fall in oil prices, which has carried over from last year into early 2016, should inject further cash back into consumer pockets.

Stocks driven by buoyant UK consumer spending have been a major contributor to the performance of our portfolios in recent years, and we expect this to continue in 2016. Furthermore, interest rates are unlikely to rise until the second half of this year, in our view.

In addition to this positive background, our consumer-related stocks enjoy individual growth drivers. ITV, for example, is benefiting from the strength of consumer spending, which is boosting advertising revenue. But it enjoys a further boost to growth via sales of content around the world. It is buying content providers, which tend to be scarce; a strategy that is not only boosting and diversifying revenues but reducing the business’ vulnerability to any downturn in advertising.

Meanwhile,, the leading price comparison site operator in the UK is gaining from both robust consumer demand and the growth of online transactions.

Time to deliver

We also expect the encouraging levels of M&A activity from last year to continue in 2016.

For example, we supported the communication business Sepura’s May 2015 purchase of the Spanish wireless communications firm Teltronic. The deal will give Sepura the scale and technology needed to enter the prized US market. We also backed ITV’s acquisition of Leftfield Entertainment in 2014 and Poldark-producer Mammoth Screen in 2015. Both deals are part of ITV’s strategy of building up its content revenue.

Another of our holdings, DS Smith, the leading packaging company, has acquired a number of companies across Europe in recent years. Last December, it also announced plans to expand in Turkey by purchasing a packaging business in Istanbul.

Next Fifteen Communications Group is a digital marketing communications and public relations group, which made a number of acquisitions last year and is promising further acquisitions and investments in 2016.

We expect to see the benefits of all these deals over the next 12 months.

The bright side of dividends

Given that a number of major companies cut or suspended dividends last year, it is easy to see why some investors have a negative view of the outlook for dividends in 2016. Indeed, journalists have been busy in recent months scribbling articles about potential dividend cuts among oil stocks, mining companies and other large cap stocks, which are paying uncovered dividends, where at least part of the payment comes from reserves.

However, there is another side to the story. There are also a number of companies with conservative payout ratios where there are good prospects for dividend increases. The current state of balance sheets in the UK corporate sector is healthy overall and not all of the cash that companies generate will be spent on M&A.

Companies such as ITV, the London Stock Exchange, UDG Healthcare, and easyJet could increase their payout ratios or pay special dividends.

The latter are typically cash distributions, which are larger than a company’s standard dividend payment. They reward shareholders and also provide evidence of a company’s strong financial position. Paying a special dividend rather than simply increasing the existing payout ratio brings advantages to companies. Investors might, for example, anticipate that a higher dividend will be sustained.

Amazon’s merry Christmas

Expectations for the Christmas trading updates from retailers were low given the adverse weather conditions in December. High margin clothing products, such as coats, remained on the hangers, prompting a round of promotions and sharp discounts. Even so, a number of clothing retailers have reported results that still managed to disappoint the market. The list of those affected continues to grow. In the privately-owned arena, Blue Inc, the fashion retailer, has cut hundreds of jobs and closed stores as part of a restructuring.

However, the indications are that Amazon UK enjoyed strong trading over the Christmas period. It experienced a record day on ‘Black Friday’, generating 7.4 million orders, up from 5.5 million last year. It also reportedly added millions of users to its Amazon Prime membership scheme. The looming threat from Amazon in the online grocery sector may also have prompted Sainsbury’s to launch its takeover bid for Argos, which has invested heavily in a distribution network to fulfil online sales. The bid was rejected.

In conclusion, a number of factors suggest the outlook for UK equities is much more positive than the early trading in 2016 suggests. Particular value can be found in a number of sectors and stocks. Moreover, a number of companies could increase dividend payouts this year and/or pay special dividends, while the benefits of increasing M&A activity should also become apparent.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 11 January 2016. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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