Following what has to be described as a phenomenal bull market in UK equities between the depths of the global financial crisis and the end of 2013, the FTSE All Share has struggled to keep its head above water over the past 18 months or so following some sharp falls.
Reasons for this slide have been well-documented, such as toppy valuations in the first instance, the gradual withdrawal of central bank stimulus, China’s slowing growth, plummeting commodity prices and, more recently, the UK’s future relationship with the European Union (EU).
FE data shows, for example, that between March 2009 and June 2014 the FTSE All Share made a hefty 150 per cent. However, it has lost 1 per cent since then, including a period when the FTSE 100 (which makes up 80 per cent of the total index) fell into a technical bear market having lost 20 per cent in price terms between its peak in April 2015 and earlier this year.
Performance of index since the global financial crisis
Source: FE Analytics
With the outlook seeming increasingly uncertain from a UK-focused and global market point of view, many suspect investors in domestic equities are in for a painful ride. 
Steven Bell, chief economist at BMO Asset Management, says whether a prolonged UK equity bear market is on the cards is certainly a pertinent.
“Looking forward, however, the relevant question for investors is whether UK equities are likely to deliver positive or negative returns over the medium-term. Recent headlines have been dominated by market turmoil, the action of central bankers and, of course, Brexit,” Bell (pictured) said.
However, to answer the question of what investors can expect from UK funds over the years ahead, Bell says they need to look at the five drivers for the current market and how they might impact the eventual outcome.
Valuations
First and foremost, thanks to the recent market volatility and sharp falls, Bell notes that it is difficult to describe UK equities as expensive.
Certainly, one of the biggest risks to an investment is the price you pay for that asset so, in that respect and given the FTSE All Share’s current P/E ratio relative to its history (as the chart below shows), Bell says investors need not be overly bearish on UK equities from that point of view.
FTSE All Share’s P/E ratio since 1985
Source: Datastream
“[The chart] shows that the current market rating is a little above the long-term average but not dramatically so. In general, equities enjoy a higher rating in terms of P/E when inflation is low,” Bell said.
“Based on current inflation observations, on this basis, UK equities appear relatively cheap.”
Dividends
What is more concerning though, according to Bell, is the outlook for UK dividends.
Many have warned about the potential for widespread dividend cuts in the large-cap end of the UK market due to macroeconomic headwinds, poor earnings growth and other operational issues and Bell agrees that this is a concern.
“Studies of the long-term returns on equities have drawn attention to the importance of dividends in total returns,” he said.
“Dividend yields in the UK are indeed high both on an international basis and relative to very low interest rates and yields on government bonds. Pessimists, however, point to the fact that the current level of dividends may be unsustainably high.”
“To assess this point we can look at the expectations on future dividends from the dividend swap market.”
Bell points out that the implied dividend swap market shows a significant decline in UK dividends, particularly over the next two years, and that by 2022, the implied level of dividends from the FTSE 100 will be 24 per cent lower than they were last year.
Nevertheless, though many have warned that current pay-out ratios are too high, Bell urges investors to asses them from a historic perspective.
FTSE 100’s pay-out ratios since 1965
Source: Datastream
“[Pay-out ratios] have risen significantly in recent years but remain close to the historical average,” Bell said.
“The oil and gas sector is critical here: it has an average dividend yield of 6.4 per cent and accounts for around 20 per cent of total FTSE 100 dividends. There is, of course, a range of companies, from those where pay-outs look stretched to those where dividends are likely to rise.”
“The key driver is, of course, earnings themselves. There is room for the pay-out ratio to rise from current levels but, for dividends to continue to grow in absolute terms in the long term, underlying earnings will need to show sustained improvement.”
Corporate earnings
Again, though, Bell warns that analysts’ estimates for year-ahead earnings have been consistently over-optimistic, with last year seeing a severe decline in growth expectations.
However, there are some grounds for optimism in this respect, according to Bell.
“First, after the battering they have received in recent years, analysts are understandably more cautious in their estimates for 2016. There is now a lower hurdle to beat”.
“Second, some of the key reasons for weak earnings may be reversing. Sterling has weakened and this results in a straightforward translation gain for foreign earnings, which account for 70 per cent of the total.”
Relative performance of currencies over 1yr
Source: FE Analytics
“Third, oil and other commodity prices remain depressed but they are above their lows. We expect commodity prices to continue to recover.”
The chance of recession
While many say there has been little correlation between economic growth and equity market returns over time, Bell says fears of a global recession is something investors need to consider. 
“A broader concern relates to the risk of recession. World growth remains positive but anaemic and some commentators fear that the recent rate hike by the US Federal Reserve and the associated tightening in financial conditions might tip the US over into recession.”
“Yet the Federal Reserve is tightening at a time when inflation is low, which could serve to extend the economic upswing rather than end it. The discussion thus far does not add up to an especially bullish picture. Dividends are stretched, earnings have been disappointing, world growth is weak and the US Federal Reserve is tightening.”
“There is, however, one important factor that suggests that equities might be attractive after all: the low level of interest rates.”
He says this provides powerful support for equities in two distinct ways.
First, equities are the beneficiary of future earnings and dividends, and interest rates represent the discount rate by which they are converted into present values. Low interest rates imply high equity prices.
“In addition, low yields on bonds push investors into equities, the so-called ‘equity refugee’ effect.”
Brexit
The final potential driver is one that has become increasingly talked about within the industry – Brexit.
The referendum over the UK’s relationship with the EU will take place in June and many expect the uncertainty around it to cause market volatility. Unlike the likes of Neil Woodford, Bell says an ‘out’ vote could have negative longer term ramifications of the UK market.
“The tension between these forces is one important reason why markets are likely to remain highly volatile.
“Another is, of course, Brexit. Whatever the longer-term impact on the UK, a vote to leave would involve an extended period of uncertainty as trade arrangements are re-negotiated and companies adjust to a new regime.
“This would obviously be bad for markets but sterling would also likely decline which would provide some support. Since the market is factoring in the risk of both outcomes, a vote to remain would likely lead to the opposite.”
Bell’s outlook
All told, though, Bell says a bear market for UK equities isn’t on the cards. However, that’s not to say returns are going to be easy to come by.
“Taking all these factors into account, we expect the returns from equities to be low but positive overall in the next few years. Equities look unattractive except when set alongside the return on the alternatives in the form of cash of government bonds,” Bell said.
