Is the market too optimistic about UK domestic stocks?

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UK-focused companies are returning to popularity with fund managers as the UK economy shows signs of recovery. But is the stockmarket being overly optimistic about UK consumer growth?

Recent figures from the Office for National Sttistics showed that GDP rose by 0.6 per cent during the second quarter of 2013, while the IMF’s upgrade in its forecast for the UK last month also points to signs of life. 

Standard Life Investments chief international economist Douglas Roberts highlights rising consumer confidence and a positive shift in employment data as “two distinct positives” for the UK.

Roberts points to the latest data from marketing company GFK, which indicates that UK consumers’ confidence about their finances has returned to levels not seen since 2007-08. 

He also sees a “big improvement” in the field of jobs, which has shifted from the initial post-recession picture of being largely supported by an increase in part-time and self-employed workers to mostly full-time positions today.

Elsewhere, Roberts notes early indications from recent Bank of England Agents’ reports and the British Chambers of Commerce that more businesses are aiming to export. “This is not a groundswell change but it is an encouraging sign,” he says.

The progress towards a UK recovery has prompted some UK equity managers to return to UK-focused companies. However, others question the sustainability of the rally in consumer stocks against the pace of economic recovery.

Some domestic names including Dixons, ITV and Howden Joinery have seen share prices rise by about 60-70 per cent this year. 

Housebuilders such as Persimmon and Taylor Wimpey have seen their shares rise by 60 per cent over the same period, buoyed by the Chancellor’s Help to Buy initiative. 

Rathbone fund manager and chief investment officer Julian Chillingworth has recently turned his attention to a number of recovery stories that also play to improvements in the UK economy.

Chillingworth, who runs the £62.8m Rathbone Recovery fund, has been revisiting Halfords, a long-term holding, which has benefited from both internal improvements and its links with the UK consumer.

He says: “It is a very domestic business in a niche area which also neatly dovetails into the increase in consumer confidence in the UK, where people seem to be happier to go out and spend more money.”

The fund recently bought a stake in LSL estate agents as a play on both consumer confidence and the uplift in the housing market, Chillingworth says.

JP Morgan Claverhouse investment trust manager William Meadon holds a stable of UK names including retailer Dixons and housebuilders Barclay Homes and Taylor Woodrow. Meadon argues that consumer stocks, particularly the housebuilders, can be expected to continue growing, even after the recent rise in their share prices, as they partake a “gradual healing process” that is taking place in the UK economy.

“We think housebuilders have got very good momentum,” says Meadon. “Valuations may not be as cheap as they were but they still look reasonable value to us. The recovery is going to be pretty muted but there is a gradual healing process going on in the economy. This is an environment where these types of companies flourish and are actually benefiting from the tough economic backdrop.”

Standard Life Investments UK equity manager Ed Legget continues to hold several housebuilders and other consumer stocks, including Howden Joinery. However, he warns that domestic stocks could “disappoint” if the recovery does not progress as quickly as hoped.

He says: “The stockmarket is generally pretty optimistic on UK consumer [stocks] and a lot of this optimism has been priced into shares already.

“Not to say that share prices cannot go higher but there might be some disappointment if things do not get better as fast as the share prices suggest.”

Legget, who manages the £626.1m SLI UK Equity Unconstrained fund, does see further to go in some domestic stocks, such as pub company Enterprise, car dealer Pendragon and logistics company Wincanton.

For the time being he is focusing on opportunities in UK equities that have exposure to Europe and emerging markets as well as commodities.

Much of the debate on how much growth is left in domestic names reflects a wider debate about how secure and self-sustaining the economic recovery will prove to be.

Roberts, despite seeing several positive changes in the economy, also notes a remaining challenge for the UK. He says: “A self-sustaining recovery depends on growth in two factors: jobs and credit.

“There is some evidence that jobs in the UK are on a reasonably firm path but I do not think there is a strong case that credit is growing strongly. It is going into housing but not into businesses.

“I do not think you can be confident that a self-sustaining recovery is in place until you see stronger credit growth.”

Bestinvest managing director Jason Hollands argues that the market’s reliance on the new Bank of England governor Mark Carney to encourage bank lending could lead to disappointment.

“The one thing that has been missing, which you would expect to fuel a sustained recovery, is strong bank lending,” says Hollands. “The market is expecting quite a lot of Carney and much more action to encourage this bank lending.

“While we think the recovery is gaining traction, there might be a little bit of optimism priced in based on this, and the risk is that the market ends up being disappointed because it is expecting too much of [Carney].”