UK equities have enjoyed a steady upward trajectory since the lows of the global financial crisis, as companies’ profits have recovered, valuations have risen and central bank quantitative easing has provided liquidity support.
Admittedly, returns have been subdued over the past 12 months as UK markets have had to contend with falling energy and materials prices, anaemic global growth, Grexit woes and political uncertainty in the run up to the general election. However, taking a longer-term view, the backdrop from here is a positive one and supportive of future growth.
While there is no denying very real exogenous risks remain, there are three key reasons I believe UK equities should have a prominent place in any portfolio seeking to achieve strong, long-term risk-adjusted returns.
1. Strengthening economic outlook
While UK GDP has pointed to slowing economic growth over the past few quarters, there have been recent signs the economy is improving. Growth has been affected by UK election uncertainty, the future of Greece in the eurozone and widespread disinflationary pressures. However, the latest IMF World Economic Outlook, published in July, has forecast much-improved full-year growth for 2015 of 2.4 per cent, second only to the US in the G7 group of developed economies.
Business investment growth remains strong and household real incomes have started to realise the benefit of lower energy and food prices, which should see a rebound in consumption over the coming months. This should help inflation tick higher back towards the Bank of England’s 2 per cent target, although this is likely to be a gradual process with record-low rates likely to be maintained.
Other bright spots for the UK economy include the labour market, which has been consistently performing well. Unemployment dipped to 5.5 per cent earlier this year – the second lowest in the EU after Germany – against a backdrop of improving real wage growth.
2. Stable political and regulatory environment
In the run up to May’s general election, uncertainty and nervousness deterred many investors from allocating further to UK equities. Although the majority Conservative party victory was a surprise, I believe the political environment is now set fair for many years to come and the strong regulatory framework associated with investing in the UK is also a key benefit for investors.
The Conservative party has been supportive of investment and job creation thus far, not least through their bold move to reduce corporation tax rate from 28 per cent when the coalition government was formed in 2010 to 20 per cent today. This is now moving even lower to 18 per cent in 2020, as announced in the recent Budget. This will give businesses confidence they can plan for the future and invest for the longer term.
While the current UK budget deficit of 5.5 per cent is still relatively large by historical and international standards, this is forecast to be eliminated by 2019/20 on the back of continued government spending cuts and structural reform. This is in stark contrast to the US, which is forecast by the IMF to run a wider deficit for the foreseeable future. This “cut less, grow more” strategy is contingent on the US economy outperforming and effectively outgrowing its debt obligations.
The UK’s approach to cut the deficit more now offers greater reassurance and economic growth potential over the medium term and is more conducive to increased business investment and confidence.
3. Corporates in good health
UK corporate balance sheets are in much better shape than they were prior to the global financial crisis as years of deleveraging have seen companies restructure cost bases, drive down working capital and refinance debt at very low levels. This has left companies with much leaner capital structures from which they can build for the future. The capital strength of UK banks, in particular, has improved in recent years.
The general improvement in cash balances has given companies options in terms of reinvesting for future growth or returning capital to shareholders. There is already evidence of a strong increase in M&A activity in the first half of this year relative to last. Data from Thomson Reuters shows inbound foreign M&A into British companies jumped by 231 per cent from $49.3bn to $163.3bn, as acquirers look to take advantage of strong balance sheets, low borrowing rates and attractive relative valuations. We continue to focus on companies able to generate cash and whose management teams have the ability to re-invest that cash, either organically or inorganically through acquisitions, to compound long-term shareholder wealth.
Simon Brazier is manager of the Investec UK Alpha fund.