A combination of currency weakness leading to a dividend bonanza and the yield differential between equities and gilts means the outlook for UK funds is increasingly positive, according to Royal London’s Martin Cholwill, who says that while volatility is bound to increase, barring a recession, there is little to suggest the FTSE’s rally will come to a crashing halt. 
Almost paradoxically (especially given the rhetoric surrounding the market prior to the EU referendum), the FTSE has been on a barnstorming run since the UK voted to leave the bloc as sterling has weakened and the Bank of England has loosened monetary policy.
According to FE Analytics, the FTSE 100 has now delivered a total return of 8.58 per cent since Brexit became a reality and, despite all the political and economic uncertainty the vote has created, the blue-chip index is marching towards the 7,000 barrier at its current level of 6,914 (at the time of writing).
Performance of index since EU referendum
Source: FE Analytics
Many have suggested, though, that this rally is unsustainable.
Firstly, trading volumes are going through their annual summer lull, the rally has merely been powered by currency movements and corporates are soon bound to feel the pinch of Brexit – plus there are certainly headwinds on the horizon in the form of the increasingly neck-and-neck US presidential election.
However, Cholwill – manager of the five crown-rated Royal London UK Equity Income fund – says there is hardly euphoria within the market given the amount of cash sitting on the side lines waiting for the market to correct.
“I think the stock market’s reaction to Brexit is very interesting,” Cholwill (pictured) said.
“We were already in a world deprived of income and the Bank of England has just made income even harder to find, so the yield from the stock market has been attractive in relative terms.”
“I’m sure we will see a pick-up in volatility and August’s trading volumes are low, but thin markets can also create big share price declines as well as rallies. I think a number of fund managers are also keeping a lot of cash at the moment, perhaps waiting for a buying opportunity, but that means the liquidity levels in the market suggest there isn’t going to be a huge amount of selling.”
Cash weightings in the IA UK All Companies and IA UK Equity Income sectors
Source: FE Analytics
The major reason Cholwill is constructive on equities relates to the once major concern facing the UK market: the outlook for dividends.
Going into the year, the consensual view was that more and more companies would have to join the list of stocks that were forced to cut their dividends in 2015 as earnings growth was weakening (leading to lower dividend cover) at a time when pay-out ratios were on the rise.
However, while a number of companies did indeed reduce their pay-outs earlier in the year, the recent Capita UK Dividend Monitor forecasted a ‘dividend bonanza’ from FTSE-listed stocks due the fact a large proportion of income-payers report in US dollars and euros (and therefore benefitted from sterling’s Brexit-induced declines).
Cholwill says that this dynamic, along with an attractive yield of 4 per cent or so, means very good news for the market as a whole.
“While more companies have cut this year like BHP Billiton, Rolls Royce and Barclays, 2015’s cuts have filtered through and have had an effect on 2016’s overall payments. As such, I think we will see flattish dividend growth in 2016.”
“However, thanks to the amount of international earners in the large cap (and mid cap) space, I think the forecasted 5 per cent dividend growth in 2017 looks underpinned.”
He notes that these predictions are predicated on anaemic economic growth (which the Bank of England has forecasted), not a recession, which does create an element of doubt thanks to Brexit and it’s so far incomprehensible economic affects.
Cholwill added: “But I think, thanks to currency weakness, we will get good dividend growth which just makes UK equities more attractive.”
“While, yes, we might see a pick-up in volatility over the coming months, support from dividends will mean the outlook for the UK equity market is positive.”
That being said, it is easy to see why some are much more bearish on UK equities than Cholwill.
Indeed, the market has rallied a long way in a very short period of time. As such, there are a growing number of market commentators who believe the UK equity market is overvalued.
“A near-term worry is that UK stocks appear expensive, based on their current valuations, relative to their history and a shrinking of profit margins across many sectors,” Nigel Green, chief executive officer at deVere Group, said.
However, Cholwill says, now more than ever, investors need to focus on equities’ relative valuation to bonds.
“I think you have to bear in mind just how far gilt yields have shifted. We have seen nothing like that from equities,” he said.
FE data shows, for example, that thanks to a general flight to safety after the vote and the MPC’s decision to slash interest rates to 0.25 per cent and embark on a new QE programme (which also includes mopping up corporate debt), the yield on a 10-year gilt has plummeted by 58.49 per cent since the referendum.
Performance of 10-yr gilt yields since EU referendum
Source: FE Analytics
It means that a 10-year gilt now yields just 0.55 per cent.
Cholwill added: “While P/Es have moved, it’s not difficult to argue that equities look even more attractive relative to bonds. As long as we avoid recession, a 4 per cent yield (which is supported) from equities looks pretty attractive.”
Neil Wilson, markets analyst at ETX Capital, says that while the outlook is far from clear, he agrees that it is hard to make the case that equities are necessarily expensive in the current environment.
“Price to earnings ratios have exploded this year. From bouncing around the mid-teens for years, P/E has shot up to almost 40 as earnings have missed their mark,” he said.
“Earnings will need to pick up to cover dividends, with the current dividend cover looking very thin at present. To this extent, a sustained rally in oil prices and UK house prices would be welcome, but not to be relied upon.”
“Nevertheless, as government and corporate bond yields tumble, in the short term UK equities look more and more appealing to yield-starved investors.”
Cholwill has one of the strongest long-term track records in the IA UK Equity Income sector.
Since he took charge of the now £1.6bn Royal London UK Equity Income fund in March 2005, it has been the third best performer in the peer group with returns of 189.07 per cent and beaten the FTSE All Share by 65 percentage points thanks to his focus on companies with strong balance sheets and leading market positions (as well as an overweight mid-cap position).
Performance of fund versus sector and index under Cholwill
Source: FE Analytics
It has also beaten the index in each of the past six calendar years and has been top-decile for its risk-adjusted returns (as measured by the Sharpe ratio) over Cholwill’s tenure.
