UK equities – 2020 outlook

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  • 14 mins 41 secs
As the new year begins, Chris St John, Portfolio Manager, Framlington Equities and David Page, Head of Macro Research give us their thoughts on the state of the UK economy as we head further into 2020, whether we will leave the EU come January 31st and how worried should we be about so-called ‘zombie companies’.



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UK equities – 2020 outlook

Mark: With their outlook and some thoughts for 2020 and what lies ahead this year. I'm joined now by David Page. He is head of global macro research at AXA Investment managers and by his colleague Chris St John, who's UK portfolio manager at Framlington Equities. David, if I could start with you, we've got the general election out of the way. All eyes now on Brexit. What state is the UK economy in for 2020?
David: Well, I think it starts the year relatively fragile. We've had a lot of uncertainty over the course of 2019, we’ve had very slow growth, we have a global economy that's relatively soft. And as we move into 2020 now, we're starting to see some of that uncertainty start to fade. We know we'll leave on the 31st of January, given the events of what happened at the back end of last year. But we are still in the dark little bit as to whether or not we see a transition that ends at the end of this year or in fact extends for a couple of years. We think the government's going to extend that transition and ultimately across the course of this year that should provide some backdrop for investment to pick up. But on top of that, we're also expecting the government to announce some fiscal easing. So, I think across 2020 we should see some accelerations, some firming of economic growth. And that's gonna provide a little bit more confidence to the economy more generally speaking.
Mark: And Chris, given that backdrop, what does that do to the valuation of the UK equity market?
Chris: I think it should be pretty supportive for UK equities. Since the Brexit vote, we've seen nothing across the UK equity market other than net equity outflows. They've been very considerable and its left global fund managers, I think very underweight in the UK, very underweight in sterling and any reversal of that, I think would very supportive to the markets.
Mark: So, to what extent is the UK market, a domestic market, giving you exposure the UK economy and to what extent is it really a play on global equities?
Chris: Yes, the all share itself is much more play on global equities, 70% of the earnings of the all share comes from international markets. The FTSE 100 is up about 80%. And even when you look at the mid-cap area of the market, which is viewed principally as a domestic UK market, even their half of the earnings comes from international markets, in fact outside of the UK.
Mark: David. You mentioned the government here in the UK really want to get ahead with Brexit. Do you think it's like to get it all done by the 31st of January? Or was that just an election slug?
David: No, I think they'll get the UK out of the EU by the 31st of January, obviously the passage of legislation we saw at the back end of last year, and then what we're expecting to be quite an aggressive this January, as they pass a lot of legislation to facilitate that will, I think, allows to leave the EU. That's not really where the uncertainty lies, the uncertainty then lies in what happens next. The withdrawal agreement allows for a transition period to cushion effectively the shift to a new trading arrangement while that new trading arrangements negotiated and it allows it either to end at the end of 2020 this year or to be extended a little bit further and the reality is it's going to be very difficult to see the UK economy and the government negotiate a trade agreement by the end of this year, but the government's got to make its mind up by mid-year, that's what the legislation suggests. So, for now, the manifesto pledge is that they're not going to extend. And that leaves us with the chilling uncertainty that, A, you could see a rushed trade agreement, which wouldn't be great for the UK economy. Or perhaps worse, that you would fall back onto WTO trading arrangements, which, after the very embedded trading arrangements that we've had within the single market, would be quite an abrupt hit to the economy. I mean, it's equivalent to the no deal that we were concerned of both in March last year and October last year. So that's where the uncertainty lies. But I think because of the, partially because of the size of the impact that the economy would suffer from that abrupt shift, partially because of the size of majority that Johnson got at the last election, it allows them a little bit more to play with and so we do expect him to reneged on that that manifesto pledge and actually sort of push that transition period out, probably to the end of 2022.
Mark: Chris as you talk to management of the company's you're invested in, are you feeling a bit more confident now? It's a bit more certainty on where UK PLC is going.
Chris: Yeah, it's a little too early to tell, but management teams have certainly been affected by the uncertainty. It certainly put off certain investment decisions. I would say it's held back and It's logical that it's done so, I think that it's held back certain recruitment decisions and as increased clarity comes, so will increased investments, I think. There's plenty of opportunity for these UK companies both domestically and internationally. They just need the confidence to get out there and invest.
Mark: The Tory party manifesto wasn't the most detailed manifest on offer, but they did have a few things in there. Not least, they're very keen on their green credentials. They want to create two million new high-quality jobs in clean energy. They want to see 2.4% of GDP being spent on R & D across the economy. What's in there that gives you some clue as to where? Well, where the UK economy could be going in the long term?
David: Well as you say, not a lot, really. The openness of the manifesto gives them a great scope to push policy in given directions, but they haven’t really committed to that much. Really, the clues that get us to where they want to go, come more from prime minister and the chancellor, the prime minister's campaign for six months effectively on the back of increased investment into the UK economy and the chancellor has changed the fiscal rules that the government's committed to, now targeting the current budget rather than the headline deficit, which means that they don't quite class investment spending as adding towards their targets anymore, and that creates quite a scope for additional investment spending and that's where we think they're going to step into. Now, there's very little in the manifesto that commits them to that. They're talking about an eight billion increase in investment over the next four or five years, which is very small beer, but they have the scope to increase by about 20 billion per annum. More recently, obviously, we've seen the prime minister talking about investment into the new constituencies in the Midlands and in the northern areas. So, we do expect to see the government provide significant more investment. We expect that to contribute some of the R & D targets that they're obviously aiming for and of course, once they clear up some of the Brexit uncertainty, we would hope see private investment start to recover as well. But at the moment, at the start of January, we're still a little bit uncertain as to what direction the government's going to take us in. I think the next clues are going to come up really when we get to the budget, probably next month.
Mark: Chris, we've had a decade of low-interest rates. As you look at companies across the UK, how's that starting to affect their behaviours? We’ve heard a lot in the last few years about so called zombie companies. What’s your take on that?
Chris: Yeah, I think it depends which geography you look at. If you're going to make sort of general comments about it, I'd say UK businesses on the whole, and if you look at, say, the mid-cap space, if you need to take a sort of proxy for the UK economy and UK investments space, there's been this ongoing arbitrage, increasing arbitrage between the cost of debt and the equity income on stocks. And if you look at the mid-cap space, the spread between BBB corporate bond yields and the FTSE 250 earnings yield has been very, very wide. What does that mean? That means well, you can issue debt very cheaply, and you can buy earnings, which significantly cover the cost of that debt, now in the US market, what's happened in the mid-market space is that companies have geared up their balance sheets. Companies themselves have taken on the debt, they’ve bought back their own equity, and they've increased their earnings per share. But as equity holders, we are, you know, the least preferred creditor on the balance sheet in the insolvency act and as that that number has gone up, so it's pushed more risk into the equity. Now, if you look at the UK market that hasn't happened. That arbitrage hasn't been taken advantage of by UK companies, principally because I think UK fund managers are still, after the global financial crisis, very, very careful in terms of how much debt they want these businesses to hold. So, what we're now seeing is external bodies, external corporate bodies coming in and taking advantage of this, private equity in particular, but other corporates, who can effectively issue their own debt at very, very cheap prices and then, buy UK PLC, at pretty depressed levels.
Mark: So, are you seeing a shrinking UK equity market at the moment?
Chris: There has been a long-term trend of the market shrinking, there has been a de-equitisation over many years. It's not happening to the degree where were struggling to find investment ideas. And interestingly, with, you know, already post the general election outcome, I sense the IPO market is going to see a little more action, particularly if UK funds start to see more inflows, which we’re just starting to see the beginning of.
Mark: And in terms of the economy, overall, you've given us a backdrop on that of it beginning to pick up. How long can the economic cycle continue for, David? $64 million question!
David: Well, I mean, obviously that's really out of the hands of the UK economy and the UK government, it tends to be more of a global question, and obviously to some extent there's no time limit on an economic cycle. But we are starting to get a little bit cautious. We certainly think that from a US perspective for example that the trade deal is going to, and the global stabilization should help to see 2020 as a relatively good year. But we do think they're sort of end-cycle pressure's starting to materialize. We expect some of those to become more obvious after this summer. In fact, we expect the Federal Reserve towards the end of the year to start recognising some of these and start easing monetary policy again. We're a little bit cautious about the scale of the slowdown that’s likely to emerge in 2021. I mean in principle, the economic cycle could go on for a little bit longer and there are a lot of uncertainties, of course, as we look a little bit further, we've talked about the UK election, there’s a US presidential election at the end of this year, and that could have a meaningful impact, not just on the US economy, but more broadly. But for now, we are cautious about the outlook for 2021.
Mark: But if the US calls a truce to its trade war with China, might it be tempted to start one up with Europe, and including the UK as part of that?
David: Well, I think part of the reason that the US has scaled back its aggression with China across the course of last year was the realisation that rising trade tensions across the board were having a significant economic impact. You know, we talked about uncertainty from the UK because of Brexit. We were starting to see a lot of uncertainty impact on the US economy because of these trade tensions. So, in that sense, I think the US government, particularly the White House pulling back on some of that aggressive trade decision was with a view to try and cement growth across across 2020 and frankly, to make sure that the election goes the way they want at the end of this year. So I don't think it makes much sense from that perspective to substitute one form of trade aggression with another. If they did so, beyond the old champagne tax here or there, then I think you'd be back to square one. And I think that the global economy would struggle a little bit more. But it does ask questions about what, for example, a second term under President Trump might deliver, might we at that stage, see the US revert to a more aggressive tone with China to try and tease out some of the strategic issues and what might that mean for the global economy in 2021 is another question as well.
Mark: Chris, you mentioned that UK PLC, in general terms, is perhaps less leveraged than the states on is on a lower valuation. Is now a good time to be looking to buy U.K. equities?
Chris: This is a question I always try and avoid answering. If the last few, UK equities are very under owned, we have increased certainty, which is good typically for equities. Um, given the outcome of the general election, I could see, I think, given the last few days I think is reflective of that, there seems to be increasing appetite to increase exposure to UK equities and that capital flow is certainly supportive. Quite often when I see investors, they're talking about 'is now a good time or not?' and to my mind that's really talking about timing, market timing. You know, if you believe in the UK equity market is a good place to invest, and you believe in businesses that are increasing their economic output should be worth more overtime then, yes, I'd say now is a good time to invest. But then I would give you exactly the same answer 12 months ago and I expect I’d give you the same answer in 12 months’ time as well.
Mark: Alright, well, final quick question for each of you, we’ve talked through quite a lot of themes and topics in the last 10-15 minutes. One key thought to leave people with for 2020 on the economy. What would it be, David?
David: Well, I think the issue is going to be one of what uncertainty does for the economy. We think it's had quite a material impact over the last couple of years and it is fading, so I think that gives us an upside for the start of the year, we're just a little bit cautious about where that goes, so I think as ever, we’ll watch valuations, we’ll watch some of the exuberance that comes through to markets, but we are mindful that we could see something of an overreaction to the upside If that comes through in the first half of this year.
Mark: And Chris, one of the risks you want to be taking with client money, what are the ones you want to avoid?
Chris: Well, UK equities are good value, they're under owned, we have a market of global market leaders of UK market leaders. We have fantastic corporate governance. We have great legal structure, which means you actually own what you buy. So, back those winning franchises that are well-capitalized and have those compounding growth characteristics? A slightly stronger UK economy does not make every company a good company overnight. And, I think we'll certainly enter a period where discerning stock picking will certainly add value.
Mark: We have to leave it there. Chris St John. David Page. Thank you for joining us.
Chris: Thank you.
Mark: Thank you for joining us. From all of us, here. Goodbye for now.

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