The UK equities landscape: Waste land or garden party?

  • Written by 

    Will Hobbs, February 2015

  • 11/02/2015

Searching for a way to invest in the resurgent UK economy? Ignore the FTSE 100, where the overwhelming majority of revenues originate from overseas. However, if you are seeking a measure of exposure to the potential for a recovery in the oil price, then the large-cap UK equity space may be of interest.

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Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

For over a decade now, UK equity investors have, more often than not, been much better off focusing on the mid-cap FTSE 250 over its more widely-known large-cap sibling, the FTSE 100. (Figure 1) In the last 10 years, you would have doubled your money investing in the FTSE 100 when dividends are taken into account. However, the FTSE 250 managed to double that return again. The textbooks might suggest this is a good example of the rewards due to those investors who assumed the extra risk of investing in smaller, less liquid, more volatile businesses. In the real world, the relationship between risk and return is often much less dependable. And so the debate continues over: 1) how much UK equities to own in a globally diversified portfolio, and 2) which part of the stock market do we see rewarding investors best over the coming 12 – 18 months?

FIGURE 1: FTSE 100 and FTSE 250
The FTSE 250 has significantly outperformed the FTSE 100 in the past

Babies, central bankers and investors…

It is set to be a busy year for the UK. Newborn babies may not be the only ones already recoiling at the thought of the country’s politicians puckering up for the general election in May. Elections bring a level of uncertainty that sits uncomfortably with investors. With another hung parliament seen as a certainty and several pretty unedifying coalition variables being touted around by various political commentators, this looks set to be a particularly tricky election for risk assets to ride out. 

Nonetheless, we see the UK economy likely to do a bit better than a still somewhat sceptical consensus. Real wages are finally starting to turn up more appreciably, as you would expect with the unemployment rate continuing to tick lower and the number of job openings still increasing. (Figure 2) That probably still suggests that this is the Conservative Party’s election to lose, despite current polls. Even if the Conservatives fail to achieve an outright majority, we still suspect that they will again be kingmakers within a coalition structure. This scenario of course carries baggage of its own, with the Conservatives promising an in/out referendum on the EU in 2017.

FIGURE 2: UK real wage growth and unemployment rate FIGURE 3: Oil prices and inflation expectations

While many in the UK will welcome this prospect, markets are unlikely to agree. There are a multitude of factors to consider when thinking about flows of both foreign and domestic investment. However, high on the list for investors is stability and visibility – a stable rule of law, a predictable tax backdrop and as much visibility on the major forces influencing the economy as is possible. A referendum on EU membership could easily crimp growth in investment at the margin, a factor that may be worth considering with reference to the more domestically-exposed mid-cap sector.

When are interest rates going to go up, and what does this mean for the various segments of the equity market?

Of more immediate concern in a clearly recovering economy is when interest rates will go up, and what that increase will mean for the various segments of the equity market. Given our belief that wages are now on a durable upward trajectory, we suspect that interest rates are going to have to rise in the UK a little faster and earlier than either the central bankers or the market are currently expecting. Falling oil prices and their corresponding effect on both the incoming inflation data and future expectations (Figure 3) have certainly released some of the pressure on the Bank of England. The most recent minutes showed that the monetary policy committee is once again unanimous in its belief that interest rates should remain on the floor.1

Even so, investors should not need reminding how quickly this can change. In our view, the prevailing consensus on a total absence of inflationary pressures will crumble as the year progresses, spurred by a perkier wage growth picture, which in turn may see the Bank of England forced into action before the year end.

Similar to the uncertainty surrounding the general elections, rising interest rates are likely a more pronounced headwind to sentiment in the domestically-oriented mid-cap space over the overwhelmingly international large-cap FTSE 100.

The above factors suggest that the FTSE 250 may find it a little harder in 2015 to continue its decade-plus run of outperformance over the FTSE 100. However, there is of course more to consider. It is not just the geographic spread of the corporate revenue footprint that differs between the mid- and large-cap equity indices; they also show a markedly different sectoral composition. The FTSE 100 is much more heavily weighted towards mining and energy stocks than the FTSE 250, and many of its international peers.2 This helps explain some of the large-cap index’s relatively limp performance over the last couple of years in particular. (Figure 4)

FIGURE 4: FTSE 100 vs. S&P 500 FIGURE 5: FTSE 100 vs. S&P 500 & commodities

Figure 5 clearly illustrates the large-cap index’s strong relationship with commodities in recent years. It charts the performance of the FTSE 100 against the performance of an imaginary index comprised of 70% S&P 500 and 30% Bloomberg commodities. Statistical analysis puts a finer point on it: the composite of the S&P 500 and a commodities basket explains 47% of the daily moves in the FTSE 100 – a meaningful percentage.

The point is that to become more positive on the prospects for returns from the FTSE 100, you have to be comfortable with the commodity exposure you are implicitly taking. For much of the last few years, our underweight position in commodities at the Tactical Asset Allocation level has been a significant part of our decision to focus our recommendations within the developed market equity space away from the UK large-cap space and more towards equity markets in Continental Europe and the US.

The stomach-churning falls in most commodity prices, particularly oil, since last summer have certainly eaten into much of the downside potential for commodities. However, we are not yet confident that commodity prices are on the cusp of stabilising or even rebounding, necessary for a more positive view on UK equities relative to their developed market peer group.

Where to go within the UK?

In light of all these influences, how do we view UK equities in an international and UK-specific context? The mid-cap, more domestically-oriented FTSE 250 has consistently outperformed the large-cap, almost wholly internationally-oriented FTSE 100 for over a decade. As we look into 2015, the domestic backdrop for the FTSE 250 is likely to be complicated in the first half of the year and perhaps beyond by the approach of general elections and some fairly unsightly coalition possibilities. The approach of interest rate hikes may also hit sentiment within the FTSE 250, which carries a greater weight to UK-exposed Consumer stocks3 than the FTSE 100. The prospects for the FTSE 100, however, are far more likely to be driven by the outlook for commodities.

INSERT FIGURE 6: Relative earnings per share (EPS) – FTSE 250 vs. FTSE 100

Finally we come to valuation. The FTSE 250 tends to trade on higher valuation multiples than the FTSE 100, whether you examine price-to-book, forecast earnings or realised cash flow. Some of this is a function of the FTSE 100’s exposure to lower-growth (Figure 6), more defensive businesses, which tend to be rewarded with lower valuation multiples, with much of the rest explained by its high weighting in commodity stocks. The picture is no different now. The FTSE 100 trades at a significant discount to the FTSE 250 on a range of different metrics. However, the distinction now is that the FTSE 100 is starting to look inexpensive relative to its own history on this same range of metrics, while the FTSE 250 is trading towards the top end of its rolling 10-year averages. (Figure 7)

Conclusion

We are certainly warming up on UK stocks. The large-cap space looks amongst the most unloved of its developed market brethren, and the time to call the bottom in commodity markets is no doubt approaching. We are not quite there yet, but investors with space in their portfolios may want to consider starting to add to positions. In terms of the more

domestically focused mid cap space, we now see sufficient headwinds, in spite of our still strong belief in the UK economic recovery, to suggest that investors may look for better entry points through the year.

INSERT FIGURE 7: MSCI UK indices – Price / Cash Earnings ratios

Equity investing involves risk including loss of principal. Stocks of mid-capitalisation companies tend to involve more risk than stocks of larger companies. Investments in mid-sized corporations are more vulnerable to financial risks and other risks than larger corporations and may involve a higher degree of price volatility than investments in the general equity markets. International investing involves a greater degree of risk and increased volatility.

1 Bank of England, Minutes of the Monetary Policy Committee Meeting 7 and 8 January 2015, published 21 Jan 2015.
2 FTSE and MSCI, 27 January 2015.
3 FTSE, 27 January 2015.