The UK equity market has largely disappointed this year following its strong gains in 2013.
Profit-taking from last year’s rally, the prospect of higher interest rates, weak economic growth in the eurozone, a falling oil price and geo-political tensions have all contributed to the FTSE All Share’s lacklustre sub-1.5 per cent return so far in 2014.
As the graph below shows, that small return has come with very high levels of volatility.
Performance of index in 2014
Source: FE Analytics
While valuations are now more attractive than at the start of the year and the economy is in better shape, a number of UK equity managers warn that volatility will remain and will overhang much of next year.
“Politics and economics will combine in 2015 to make it a potentially choppy year for investors,” Chris White, head of UK equities at Premier, said.
“In terms of politics, we have a UK election to consider in May and with the political environment so volatile, it is very difficult to predict the result.
“Whilst many in the City may feel more comfortable with a Conservative government majority or Conservative-led coalition, this brings a referendum on Europe even closer which has the potential to blow a hurricane through financial markets.”
White’s concerns are echoed by Colin Morton, who heads up four UK equity funds at Franklin Templeton.
Morton is of the view that we will continue to live in an “era of low interest rates, low bond yields and modest returns” for some time to come. While he is relatively positive on the UK economy, he warns UK equity investors cannot afford to ignore the impact of politics next year.
“Investors have limited scope to prepare for factors arising from the election outcome and, whoever’s in power, you would hope and expect most of the macro decisions to be relatively similar,” Morton said.
“However, with this election there is a real chance of something that we haven’t seen in the UK for a generation which is a coalition involving more than two political parties – which presents the risk of compromised decision-making and ongoing political tension.”
“This is a prospect which could cause a lot of uncertainty in terms of the potential impact on the bond market and on sterling.”
Star manager Richard Buxton, who heads up the £1.7bn Old Mutual UK Alpha fund, recently apologised for his relative underperformance so far this year. His fund is now slightly up against the IMA UK All Companies sector and the FTSE All Share year to date, thanks to the recent ‘Santa rally’.
This has added to his longer term outperformance as since he took over the portfolio in December 2009, it has been a top quartile performer and comfortably beaten its benchmark.
Performance of fund versus sector and index since Dec 2009
Source: FE Analytics
Though Buxton’s fund is once again outperforming, he too is concerned that it will be difficult to make money during the build-up to the next general election.
“I firmly believe that 2015 could be a year of two halves for the UK equity market,” Buxton (pictured) said.
“While the market is likely to be stuck in a narrow trading range for the first half of the year, there are some significant tailwinds that should propel it higher post-election.”
Concerns over next year’s election have meant certain global managers, such as Neptune’s Robin Geffen, have decided to ignore UK equities completely within their portfolios.
However, while Buxton is relatively cautious on the first half of 2015, he expects things to become a lot more positive at the back end of the year – especially as UK equities are trading below their long-term average forward P/E ratio.
“Just as the strength of sterling against the US dollar acted as a headwind in 2014, its current weakness, coupled with the possibility of further volatility ahead of the election, could, rather perversely, act as an additional tailwind for UK equities,” the manager said.
“This would give the market the much needed earnings growth it requires if it is to gain any traction in 2015.”
“This lack of earnings growth has, I think, postponed rather than cancelled the market’s push through the all-important 7,000 barrier. A combination of continued economic growth, together with softer sterling may mean that we finally get there in 2015.”
So, which parts of the UK equity market do the experts think will perform best next year?
While Morton has stayed well-clear of food retailers – like Tesco, which has fallen 43 per cent this year on the back of an accounting scandal and competition from discount retailers – he is now considering adding them to his portfolios on the back of low valuations.
Performance of stock vs index in 2014
Source: FE Analytics
“One sector that we have avoided for the last 12 to 18 months is food retailers as it became clear that a structural change was being driven by changing shopper behaviour,” Morton said.
“This has proved to be an important decision for fund performance as some stocks have dropped dramatically and, following that, we are now looking at the sector again very carefully.”
White is largely avoiding miners due risks surrounding Chinese growth, oil companies on the weak oil price), banks due to regulatory pressures, utilities because of political risks and, unlike Morton, supermarkets owing to falling profitability.
Instead, he says investors should concentrate on stocks which are focused on the UK consumer.
“The ASDA Income Tracker shows that UK household expenditure is in good shape, driven by falling unemployment, falling food prices and falling fuel prices. I believe these trends will continue into 2015,” White said.
“A pick up in real wage growth could mean that consumers will have around 5 per cent more discretionary income to spend than 2014. In this context, non-food retailers – such as Marks & Spencer and Debenhams – look well placed.”
“Travel companies National Express and Tui Travel look interesting as beneficiaries of the strong consumer and the falling oil price.”
He added: “Finally, with interest rates expecting to stay low for a long time, big and reliable dividend yielders like Phoenix, Sirius Real Estate and HSBC should perform well.”
