UK equities have ‘potential to rally’ in 2011

1st January 1999

Richard Buxton, head of UK equities at Schroder's, reckons that, with expectations of a double-dip now low, and increasing confidence on that front encouraging companies to be more optimistic and to invest more, UK equities could rise as much as 20-25% in 2011.

He says: "It is indeed a paradox that the worst recession of a generation has made the UK one of the most attractive areas for investors today. Having shed jobs quickly at the beginning of the recession, companies are now leaner. Moreover, strong profits this year leave companies cash rich – cash which is currently on the sidelines."

Buxton expects the ‘feel-good factor' to become more evident with a further pick-up in merger and acquisitions; currently mothballed projects to be put into action; and hiring to resume.

Encouraging economic outlook

The macroeconomic backdrop, certainly does look encouraging , with Monetary Policy Committee member Andrew Sentance saying in the Daily Telegraph that Britain's economy is recovering more strongly than in both of the previous recessions and will not be knocked off course by the spending cuts . Meanwhile, Alex Brummer of the Daily Mail points to the underlooked fact that UK's exporters are actually doing rather well.

On a global basis, Buxton says UK stocks remain relatively undervalued and offer strong recovery potential, dividend yields are growing: "Although the UK may just be a small market, listed companies have a truly global reach. These factors combined make the UK a very attractive market for investors."

Company fundamentals positive

On a further encouraging note, UK company fundamentals are also improving. Indeed corporate profits have been the bright spot of the recovery, with UK profits expected to be up around 50% in 2010. "This is a remarkable achievement, given what has been a fairly anaemic recovery so far," he says, adding: "The figures are testament to the hard fought restructuring which businesses engaged in during the early stages of the recession. The results are clear: many companies now enjoy improved balance sheets, streamlined costs and better cash generation."

Up to now, investors have been swamped by concerns that a weak economic environment will drive down the profits of businesses, with costs fixed, sales variable, and profitability collapsing. But, in Buxton's view, one of the things that investors have not been focusing on is the fact that this can, and indeed does, work in reverse.

He says: "Businesses have done a sterling job of taking out costs and, as sales come back, there will be a leveraged improvement in profits. Evidence of this can be seen today, and in the medium to long term, the level of profit that businesses can generate can still move ahead significantly in excess of what they have generated in the last 12 months.

"Companies are generating record cash flows, and enjoying record profitability, yet investment is at record low levels. Now we must see that cash put to work."

Good news from abroad

The UK may be an island but it is, of course, intimately linked to the global economy but even beyond the UK, the picture is encouraging. Buxton notes that in the US, the labour market is showing signs of further improvement, with the latest employment numbers almost triple expectations.  And, as the FT notes here, the US economy is picking up, with exports up, imports down and consumer spending increasing.

"Certainly anticipation of US QE2 was supportive of equities. With the cards now on the table, it is clear that the Fed is willing to do what it takes to avoid deflation, boost demand, and avoid a double-dip."  

As for the impact of debt on equities, Buxton, reflecting consensus opinion says it is highly unlikely that the Bank of England will raise interest rates through the bulk of next year, while an international nod of approval for deficit reduction measures increases the likelihood that the UK will hold on to its coveted AAA rating, all factors pointing to low yields.

As Howard Archer, chief European economist, IHS Global Insight, notes here in the Guardian, it is unlikely that that the Bank of England will hike rates until late 2011.

Outperformance on cards

Buxton adds: "Even if bond yields were to drift up next year, it would not undermine the valuation of equities because those yields are held artificially low by monetary policy."

Not that he is suggesting for a moment it will be plain sailing for equities from here on in: "There will undoubtedly be some external shocks. For one, European peripherals will suffer – following a period of relative calm post Greece, Ireland is back in the headlines, and this is likely to be a reoccurring issue. However, having gone sideways for 10-years – equities are now in a strong position to outperform."

See also:

Strong UK growth keeps QE at bay

European equities to deliver despite eurocrisis

 

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