The “omnishambolic state” of the UK’s political backdrop has manifested itself in investor behaviour, according to Kepler’s Alex Paget, who warns market uncertainty could mean holding out on asset allocation calls is prudent for the time being.
While the FTSE 100 performed well last year and is up 6.8 per cent year-to-date, Paget said underlying investor sentiment is seemingly at odds with market performance.
Performance of index since 2016
Source: FE Analytics
He pointed out this is particularly unusual given that sterling has strengthened against the dollar by 4 per cent so far in 2017 and the cyclically-adjusted price-to-earnings ratio of the blue-chip index is attractive relative to Japan, the US and continental Europe.
“Political allegiances aside, the market likes the Tories,” Paget wrote. “This has often been borne out in the performance of the pound after recent political events, with it falling on the back of the lack of a majority in 2010, it soaring on David Cameron’s surprise victory in 2015 and surging once again after Theresa May’s announcement of a snap election in April.
“But, sterling only “soared to a six-month high” on 18 April as it was seemingly guaranteed that the Conservatives would romp home with 200-plus seat majority and continue with their pro-business policies as Labour was on the ropes and Jeremy Corbyn had absolutely no chance of being prime minister.
“As we know, the picture is far more clouded today.”
Kepler’s research shows that regional UK weightings of open-ended and closed-ended global equity and global equity income funds are near all-time lows over 10 years.
Discounts have also widened relative to three-year averages among trusts in the AIC UK Equity Income, AIC UK All Companies and AIC UK Smaller Companies sectors.
“Strangely, the AIC UK Equity Income sector has been the hardest hit by the recent uncertainty – even though, thanks largely to the ongoing hunt for yield, its constituents have been considerably more popular than growth-orientated investment trusts since the global financial crisis,” Paget continued.
“The average discount across the peer group is 6 per cent, which is considerably wider than the average over three (3.9 per cent), five (3.4 per cent) and seven (3.5 per cent) years.
“This could, however, be more to do with the rather bleak outlook for UK dividends," he noted, adding that while trusts in the AIC UK Equity Income sector have aimed to protect investors, dividend cover across the FTSE 350 is very low at less than 1x.
The research analyst said lower gearing relative to history across the UK closed-ended equity sectors also hints at heightened levels of bearishness among the managers themselves.
He said the run-up to the election and the subsequent uncertainty is reminiscent to market conditions before the general election in 2015, when many believed a hung parliament was inevitable.
During this period, Paget said the discount on UK trusts widened due to the uncertainty a rainbow coalition would cause. Following the announcement of a Conservative majority, the average discount across the three UK equity sectors narrowed by 37 per cent.
“It is entirely possible that the market would react well and discounts on UK trusts would narrow if the public decide to go with May and reject Corbyn’s policies (which obviously have certain members of the City slightly concerned given his proposed privatisation of certain industries, increase in taxes for additional earners and increased corporation tax),” he reasoned.
“However, the political backdrop is completely different to the one presented to investors in May 2015. After all, the possibility of the UK having a referendum on its relationship with the EU was a problem for later down the line (and it wouldn’t be too much of an issue anyway, as popular wisdom at the time was that we obviously wouldn’t vote for Brexit…).
“Now though, even if the Tories increase their majority and discounts do narrow over the short-term as a degree of confidence returns to the market, two years of ‘Hard Brexit’ negotiations could well pump out continued uncertainty for the UK market as a whole.”
While it is of course impossible to predict what the result will be tomorrow morning – let alone what will happen with Brexit negotiations over the next few years - the research analyst said there are some UK equity trusts that will fare better than others depending on the outcome.
For instance, if Brexit negotiations are favourable, the economy strengthens and UK equities begin to look cheap, he said Thomas Moore’s Standard Life Equity Income trust could be an attractive option given it is trading on a 7 per cent discount which is wide relative to its history.
Performance of trust vs sector and benchmark over 5yrs
Source: FE Analytics
“It is a benchmark-agnostic portfolio of UK equities with a clear bias towards companies that generate attractive dividend growth and though its positioning hindered returns in 2016, the portfolio’s NAV is ahead of the index over the course of 2017 (at the time of writing),” Paget explained.
“If the opposite is true and investors shun UK assets all together, Scottish Mortgage (although listed on the LSE) has a very low weighting to UK equities at just 3.1 per cent - which would mean that not only would the portfolio have little exposure to potential declines in the UK market, but could also benefit from a potential weakening in the pound.
“Instead, managers James Anderson and Tom Slater of the top-performing global trust are focused on high growth opportunities in areas such as Asia and the west coast of the US, with technology-related stocks featuring heavily within the portfolio.”
For investors not wishing to make asset allocation calls, the research analyst said Personal Assets could be a good option as it can invest across a wide range of asset classes and resides in the AIC Flexible Investment sector.
Headed up by Sebastian Lyon, the four crown-rated trust is currently trading on a 0.4 per cent premium to NAV which is broadly in-line with its three-year average.
“Many may wish to sit it out and wait and see,” Paget concluded. “This seems a prudent approach as it’s clear no one has any real idea what is going to happen on Friday morning.
“As such, early next week, we will publish further research on how the election result has affected the UK market and, in particular, UK trusts.”