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Stretched valuations, dividend cuts and ‘Brexit’: How will UK funds cope with 2016?

30 December 2015

Following a tough and volatile year for many investors in UK funds, leading fund managers such as Mark Barnett, Mark Martin and Colin Morton give their outlooks for the coming 12 months.

By Alex Paget ,

News editor, FE Trustnet

It’s certainly been a topsy-turvy year for UK investors across 2015.

While the FTSE 100 broke is historic high and even graced the 7,000-plus territory earlier in the year, the UK equity market has been hit by a multitude of headwinds since April in the form of China’s slowdown, plummeting commodity prices, the Greek debt negotiations and uncertainty about interest rates.

All told, while the FTSE All Share has gained 1.10 per cent year-to-date, it has had a maximum drawdown of more than 12 per cent.

Performance of indices in 2015

 

Source: FE Analytics

Of course, it’s not all been doom and gloom. Small and mid-caps have delivered decent returns over the year as a surprising election result and an improving economic backdrop have driven the more domestically oriented FTSE 250 and Small Cap indices higher.

In fact, certain active managers in the IA UK All Companies sector with a high weighting to those parts of the market have been able to deliver 20 per cent or more to their investors this year – such as Premier ConBrio Sanford Deland UK Buffettology, PFS Chelverton UK Equity Growth and FP Miton Undervalued Assets.

In this outlook, though, we are looking at the market as a whole and with many perceived headwinds on the horizon, can UK equities recover from what has been a poor year or will 2016 have more in store – or even something more sinister?

FE Alpha Manager Mark Barnett, manager of the highly popular Invesco Perpetual UK income funds, warns that next year will be another difficult one for investors.

“In my view, the near-term outlook for the UK stock market as we approach 2016 appears challenged,” Barnett (pictured) said.

“We have seen a good recovery from the post-crisis low in 2009 and from the eurozone crisis in 2011, but the progress of corporate earnings in aggregate has been disappointing and there continues to be questions over growth potential in 2016 and beyond.”

“The stagnation of the FTSE All Share index level during 2014 and 2015 to date suggests that investors are unwilling to apply a higher P/E ratio to equities until they see better earnings growth potential in a low inflation world – and with producer prices in decline it is not obvious that this is guaranteed.”

The manager is also concerned about the impact the slowing Chinese economy will have on the internationally facing UK market.

“This will clearly have an effect on the ability of companies to increase prices, the willingness of companies to invest in new capacity and ultimately the capacity for economies to grow sustainably into the future.”

He added: “Add to this an expected gradual tightening of US monetary policy and you have a recipe for nervousness and uncertainty.”

Another source of “nervousness and uncertainty” is the outlook for UK dividends as following a number of high profile cuts, many market commentators expect more of the same in 2016 as pay-out ratios have increased, dividend cover has fallen and earnings per share (on average) has been relatively lacklustre.


 

Pay-out ratio of the FTSE All Share

 

Source: Lazarus Partnership

Of course, the large majority of this concern has been directed towards the likes of oil and mining companies given the severe weakness in commodity prices.

For example, with oil at less than $40 a barrel, many warn that BP and Shell (which are very widely held and make up a significant chunk of the index) will have to reduce their pay-outs. The likes of Glencore and Anglo-American have already had to cut while BHP Billiton is expected to follow suit given the dividend yield is more than 10 per cent.

However, Franklin UK Equity Income fund manager Colin Morton says that other highly popular stocks such as GlaxoSmithKline, Vodafone and HSBC have potentially challenged dividends as well either due to paying out their current dividends with debt or challenges to their business model.

“At best, we will see a lot of big companies with stretched dividends. At worst, we are going to see a lot of big dividend cuts,” Morton said.

Simon Brazier, manager of the Investec UK Alpha fund, agrees that 2016 will certainly provide challenges for investors as he expects debt and deleveraging to continue to constrain global growth further, uncertainty around monetary policy to persist and the market to remain sensitive to short-term news flow.

However, by focusing on more domestic stocks, Brazier says investors can find opportunities.

“The coalition government had already begun the process of fiscal consolidation and reducing corporation tax and this has continued under the majority Conservative government,” Brazier said.

“Corporation tax will be reduced to 18 per cent by 2020 and the budget deficit is forecast to be eliminated before the end of this parliament. Both of these factors will be hugely important for business investment and growth in the UK.”

“From an economic perspective, as highlighted in November’s Bank of England Inflation Report, ‘domestic momentum remains resilient’. Growth forecasts remain amongst the highest of the G7 group of developed economies, consumer confidence is firm, business investment remains strong and real income growth is the strongest it has been since the global financial crisis.”

Unfortunately, this doesn’t mean domestic-orientated companies don’t face challenges next year.

It is becoming an increasingly consensual view that the referendum on the UK’s membership of the EU will take place in 2016 and the public vote on Britain’s relationship with Brussels (like the Scottish referendum last year) will inevitably cause uncertainty which market participants hate.

In fact, the potential for ‘Brexit’ is one of FE Alpha Manager Mark Martin’s biggest concerns for the year ahead.

“With the general election now behind us, the major cloud on the political horizon relates to the UK’s in-out referendum on membership of the European Union,” Martin said.

“The prospect of Brexit does not appear to have weighed on sentiment so far, though there currently remain more questions than answers. In particular, there is as yet minimal insight into negotiations on the terms of UK membership, or indeed the timing of the referendum, which is currently slated for 2017 but could happen earlier.”

“As we gain more clarity on these issues we may see increased market volatility; whilst Brexit is a very real possibility, it is not our central expectation.”


 

Nevertheless Martin, who manages the Neptune UK Mid Cap and Neptune UK Opportunities funds, says there are potential tailwinds for the market, particularly in regard to small and mid-caps which have vastly outperformed FTSE 100 stocks over the past five years.

Performance of indices over 5yrs

 

Source: FE Analytics

 “We expect US dollar strength to persist into 2016, and to continue to drive M&A activity within the UK market as cash-rich US corporates look to take advantage of the foreign exchange differential via overseas expansion,” he said.

“The M&A cycle has already started to pick up, with major deals including Shell’s approach for BG and the proposed takeover of SAB Miller by ABI InBev.”

“We expect deal momentum to continue, particularly in the small and mid-cap markets, which should go some way to supporting the elevated valuations seen in some parts of the UK market.”

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