10th November 2014
With the British economy having improved over the past 12 months, Mark Barnett, head of UK equities at Invesco Perpetual looks at whether that rate of improvement can be maintained…
A year ago I was overly pessimistic about the outlook for employment, business investment and GDP growth; all three have performed more positively than I expected.
Economic growth has recovered to around 3% and there has been a phenomenal pick-up in employment – both the total number of jobs in the economy and the total hours worked per month are at record levels. This is encouraging news, but the questions we have to ask ourselves are: is this type of economic growth sustainable, and is it robust?
One area associated with the employment picture is wages. Underlying consumption in an economy that’s very dependent on consumption, like ours, is largely dependent on wage growth and household savings.
Wage growth over the last few years has been disappointing and, while it may be getting a little bit better, the trend is that people have been feeling worse off year-on-year. This may reflect a sort of ‘unspoken pact’ that was made between the employees and the employers during the recession.
The UK labour market effectively re-priced – it was too expensive in 2007 and it has re-priced over the last four or five years, enabling jobs to stay but wages to flat-line. As a result, unemployment has stayed low, unlike in previous recessions. But although jobs are being retained, people, in real terms, are being paid less, reflecting the current dominance of the employer over the employee.
Consumption growth witnessed in recent years has largely been boosted by a decline in the savings rate, so savings, having been built in 2007-09, have been steadily falling since then. Overall, though, consumer confidence is high. More people are in a job. But there isn’t much more money being earned, and household cash flow has remained pretty flat since the big one-off bounce in 2009 when interest rates were cut to just 0.5%. It follows that growth in UK consumption continues to depend on a fall in the savings rate or a rise in real wages.
We are starting to see signs of a possible improvement in the consumption outlook, not because people are being paid more in real terms, but because the prices of non-discretionary items – such as fuel, food and utilities – have been falling. The economy is okay – it’s neither too hot nor too cold – but, I think, the best days of the recovery probably are behind us and there could be a more moderate pace of economic growth going forward. Other potential headwinds to growth are the forthcoming UK General Election and a weakening European economy. Europe is our biggest trading partner and the softening of its economy may also impact negatively on UK company earnings.
UK equities currently, as an asset class, still look relatively attractive on a yield basis in my view. We have seen a re-rating in the equity market as equity markets performed well in the last few years. In particular since the beginning of 2013 the mid- and the small-cap indices in the UK have performed much better than the FTSE 100 index. In fact, the large-cap index is exacerbated especially by the performance of the mega-caps, which have been particularly disappointing.
Year-to-date, the UK stock market, as a whole, has gone nowhere; but there has been quite a lot of rotation starting to occur out of small- and mid-caps into some of the FTSE 100 companies. That might be also a reflection of people’s anticipations that the best of the economic recovery perhaps is behind us.
Looking at the market Price Earnings Ratio (P/E), I believe the overall market valuation is fair value, bordering on expensive. It doesn’t necessarily indicate bad returns going forward, but suggests that returns will be more modest when compared to the last two or three years.
First is the earnings outlook. In recent years, the level of earnings growth in the market anticipated at the start of the year has not been met. While in recent years share prices have continued to rise in spite of unimpressive earnings growth, this has led to higher valuations and more demanding earnings expectations. We need to see something of this earnings recovery to come through to justify where share prices have reached.
In aggregate, the earnings progression of the market has been disappointing and I would say that that remains an important headwind.
The other important issues are about monetary policy. Although in the UK interest rates will go up, I don’t think they’re going to go up this year. When they do go up, they will go up slowly and steadily, in my view. And I don’t think interest rates are going to peak at anything like the level that we saw historically.
A key factor in the US is the removal of Quantitative Easing (QE), and this has proven a headwind for the S&P 500 index whose performance has quite a high correlation with spending on QE. We should bear in mind that October is the final month of QE tapering in the US.
Offsetting some of my concerns about the UK market outlook are the yields available on the stocks I hold in my portfolios, which in my view remain attractive in terms of their relative size and potential to grow sustainably. That’s what I’ve focused on: the ability to grow dividends from this level of good starting yields is still available in the UK stock market.
I believe the current UK economic outlook is okay but not fantastic. There is only modest additional credit being extended in the economy, wages are not growing very fast, and people’s sense of wealth is dependent, largely, on prices of goods, something which is outside their control. The backdrop for equities, though, is not bad because when interest rates rise, the expectation is that they are not going to rise very fast and that they won’t peak at high levels.
In summary, over the last 12 months the economy has certainly been better than I thought it would be, although I think the outlook is okay rather than spectacular. Equity valuations, as always, remain really important. I believe they are currently relatively attractive. We need to understand, though, the absolute valuation case for any stock we are buying. I believe that the UK market does offer some good dividend yields, with the scope to grow over the long term in a sustainable fashion, and that ultimately is what’s going to drive long-term returns of portfolios.