Investors should expect another poor and highly volatile year from UK equities given the dull economic environment but high valuations on offer, according to FE Alpha Manager Luke Newman. 
It’s been a frustrating year for most investors in the UK equity market as macroeconomic headwinds such as the Greek debt negotiations, a Chinese economic slowdown, plummeting commodity prices and the prospect of higher interest rates in the US have weighed on sentiment.
While most investors in the mid and small-cap space have seen high single digit returns thanks to an improving economic outlook, the international facing FTSE 100 index has borne the brunt of these concerns.
As a result, the FTSE All Share (which is 80 per cent weighted to the blue-chip index) has ground out a return of just 2.28 per cent with a significant amount of volatility.
Of course, though, any look at 2015’s difficult market conditions should be coupled with the index’s 148.49 per cent gain since the bottom of the global financial crisis in March 2009.
Performance of index since the global financial crisis
Source: FE Analytics
Therefore, with the macroeconomic picture still murky, valuations still high and given where we are in the economic cycle, Newman – who heads up the five crown-rated Henderson UK Absolute Return fund with fellow FE Alpha Manager Ben Wallace – expects another difficult year for the market as whole.
“I see a lot of similarities looking forward into 2016 as we saw when we stood at the start of 2015,” Newman (pictured) said.
“I think markets will most likely move in a sideways to down direction. Valuations are high and I can see far more areas that are going to provide downside surprise in terms of earnings and profits than I can see in terms of positive surprises.”
There are many who disagree with Newman’s view of the market, of course.
For example, Nick Peters – who co-manages Fidelity’s Multi Asset range – says the FTSE 100 index (following its tough year) offers attractive opportunities heading into the New Year.
“Wage growth has turned positive, driven by rising employment and increases in the minimum wage,” Peters said. “This is particularly important and should help to drive a broad based feel good factor, which has been missing in the wake of the financial crisis.”
“The FTSE 100 has a high exposure to the commodity sector, which accounts for around 20 per cent of the index capitalisation. This has made it an attractive hunting ground for value managers, who are now buying companies in the energy and basic materials sectors.”
“Company management within these sectors are beginning to show greater capital discipline, cutting back on capital expenditure and channelling cash flow towards dividends. In this context, and with the potential for stabilisation or an increase in oil and commodity markets, these sectors should do well.”
However, Miton’s David Jane says now is the time to ‘de-risk’ portfolios given the mounting perils facing the equity market.
“Earnings growth is facing multiple headwinds of slow sales growth, slowing share buybacks, rising wages and rising interest charges. This may mean that forecasts for next year are likely to experience further downgrades and valuations will rise even with a flat market,” Jane said.
Nevertheless, while Newman is expecting another tough year for the index, he isn’t overly concerned. The major reason for that is because he has the ability to short stocks (both tactically and as core positions) within his £911m fund.
“The joy of a strategy such as ours is that we are just as comfortable operating in up, down or sideways markets because we can turn that lack of direction and uncertainty into a stable stream of absolute returns.”
Newman and Wallace have used that flexibility to their advantage this year as Henderson UK Absolute Return has made 6.66 per cent in 2015. On top of that, it has had a maximum drawdown of just 1.38 per cent over that time compared to 11.73 per cent maximum drawdown from the FTSE All Share.
Performance of fund versus index in 2015
Source: FE Analytics
The managers have run the strategy for close to 10 years now, but launched their Henderson UK Absolute Return fund in April 2009.
Over that time, the portfolio has returned 56.9 per cent. While the FTSE All Share has gained 115.42 per cent over that time, Henderson Absolute Return has been four times less volatile, had a maximum drawdown that is four times lower and has 10 more positive monthly periods than the index.
Thanks to that return profile and the managers’ disciplined strategy, the fund has earned a place on the FE Invest Approved List.
Going forward, Newman believes there will be certain winners and losers in 2016 and, on the long side of his portfolio, he is focusing on a particular type of company.
“Dividend growth remains a very strong set of characteristics we are trying to identify. Some of the strongest companies we can find, in what remains a dull economic environment, have the ability to grow their dividends over and above their peers and their own earnings and profit growth.”
Performance of stocks versus index over 2yrs
Source: FE Analytics
He added: “Within the UK, the likes of Legal & General, Aviva, RELX (the old Reed Elsevier) all have those characteristics and have been strong share price performers. I see that continuing, assuming we remain in a flat to low GDP, interest rate and inflationary environment.”
On the other hand, though, he thinks that certain stocks will be hurt by changing regulations in the UK.
“On the short side, we are starting to identify a new risk and that is wage inflation.”
“Unfortunately, we haven’t seen much coming organically but policy action and policy makers attempts to stimulate wage inflation in certain areas and the UK, from a global perspective, is really at the heart of that through the increase in the natural living wage which will impact a number of companies from April next year.”
“For those general retailers, food retailers, leisure companies and government outsourcers in many cases, I think we are going to see a cost shock, a genuine cost shock. I think they will struggle to see a top-line benefit of those higher costs or indeed to pass those costs on to their own customers.”
Henderson UK Absolute Return has an ongoing charges figure of 1.06 per cent.
