The resilience we’ve seen from equities this year has been counter-intuitive. The UK economy is in its fifth year of sub-trend GDP growth and it’s been difficult to see a catalyst for change. China, the key global economic driver of the last decade, is now delivering lower than forecast GDP growth and, post-Cyprus, issues with the Eurozone rumble on unresolved. Meanwhile, the US has been providing some encouraging signs, but markets will react strongly if the Fed softens its market stimulus.
But despite the disappointing background, I believe the UK stock market has further to go and investors should not consider this the top of the market. There are a few key indicators that lead me to this view.
First, UK equity valuations continue to look attractive on an earnings and cash flow basis compared with the long-run trend. Yields remain at or better than historic averages at a time of very low interest rates. So against other assets, UK equity yields are compelling. Importantly, this is true when company balance sheets are healthy, buy backs are increasing, and the dividend payout ratio is below its 40-year average, according to figures from Deutsche Bank last month.
Secondly, although shares may no longer be markedly undervalued, the relative valuation of equities compared to other asset classes – particularly cash and bonds – remains supportive. This assertion is borne out by the strong start to 2013 in the FTSE All Share Index, which has seen its best beginning of the year for some time, despite last week’s dip.
Thirdly, as long as yields remain at or better than historic averages and interest rates stay low, I see no reason why equities cannot continue to deliver robust returns. Gains, however, have not been evenly spread. Consumer defensives like pharmaceuticals are being judged as equally creditworthy as UK government bonds, but with the important difference that many offer double the income yield. Meanwhile, cyclical sectors, especially mining, have been under severe pressure, with the result that some have underperformed defensive shares by as much as 40 per cent since 2011. This divergence of performance is likely to continue.
Last but not least, the current macro environment is supportive for a range of companies. We expect high quality stocks to be positively re-rated. Firms that can grow revenues and cash flow when growth is weak, like Booker (the food wholesaler) and Restaurant Group, will be highly prized. In addition, mergers and acquisitions activity could be boosted by sterling’s recent weakness. “Self-help” companies, like B&Q owner Kingfisher, where management is improving the way the business is run, can also prosper in the current environment.
Despite last week’s dip, UK equities should continue to offer good potential for returns for some time to come.
David Lis is head of UK equities at Aviva Investors.