The steady rise in the UK stockmarket over the past 12 months has driven the FTSE All-Share index and its valuation to record levels. A return of 25 per cent is impressive for any 12-month period in the UK market but that period has rendered both the valuation and the index level vulnerable to disappointment.
Since early 2016 market performance has been driven by a more favourable environment for earnings. The outlook had already been improving over the year, supported by recovering commodity prices, but the collapse of sterling after the EU referendum provided a windfall for the two-thirds of UK companies that derive earnings overseas.
While the headline figures for earnings growth look reasonable for a number of UK sectors I worry that this currency-driven benefit has been largely accounted for and that too many risks are not priced into equities. Continued growth in underlying earnings looks unlikely.
In recent weeks we have seen the dial shift significantly for sterling following the surprise call for a snap general election. Long-term investors see the move to gain a proper mandate for leadership as likely to strengthen the nation’s position through the Brexit negotiations.
The market’s initial reaction was to drive sterling higher, reversing some of the declines suffered in June, while the internationally focused FTSE 100 index fell sharply. Given the consensus pessimism priced in over the past 12 months, it is plausible to envisage an environment more positive towards sterling.
In the event that the currency continues to strengthen, this may be sufficient to restrain further earnings growth, particularly for the FTSE 100 index.
In terms of portfolio construction and positioning, investors should be considering currency to a greater extent and seeking to invest in companies where valuations are not dependent on sterling remaining weak.
As a result of the fall in sterling the market has assumed an overly pessimistic outlook for domestically focused businesses in a number of sectors, particularly real estate, which suffered a fairly indiscriminate de-rating.
Despite the strong correlation between stocks in this area valuation anomalies remain and there are a number of companies with positive trading prospects despite fears of deterioration in the UK economy through the Brexit period. These include Derwent London, Shaftesbury and NewRiver Reit, where share prices are now at significant discounts to asset values.
Shaftesbury’s broad portfolio in London’s West End should provide resilience in the event of a softening in economic growth and consumer spending. The diversity of tenants – a mix of restaurants, leisure and retail – fulfils the trend towards a more complete retail offering, experienced through distinctive destinations and a range of activities, supporting long-term pricing power. The company aims to deliver total shareholder return via rental growth, which is underpinned by low tenant turnover and high demand.
Meanwhile, NewRiver invests in retail properties located across the UK. Its convenience-led portfolio, affordable rents and active asset management continues to support income, underpinning one of the highest dividend yields in the sector.
Sector influences are unlikely to abate in the near term but fundamental analysis at the stock level differentiates performance over the longer term.
Beyond sterling, the change in the US interest rate environment may also present a headwind for the UK market although, given the continued low inflation outlook, it is unlikely the US Federal Reserve will raise rates more than four times this year.
The overall political backdrop is the other major influence in equity markets. There are electoral cycles in many major economies, including the UK again, accompanied by a heightened threat from geopolitics that may yet prove disruptive to business confidence.
With economic and political uncertainty set to continue investors should focus on areas they see delivering returns in absolute terms, either driven by growing dividends or from company management improving financial prospects, regardless of the changing economic weather.
Mark Barnett is head of UK equities at Invesco Perpetual