This year, the UK equity market has been buffeted by the countervailing forces of better-than-expected global economic growth and ongoing domestic political concerns.
The key economic variables of growth, inflation and interest rates have aligned to drive narrow but rising market levels, low volumes of shares traded and reduced share price volatility. These conditions seem set to sustain a perfect environment for rising stockmarkets, which may prove to be the case over the near-term.
Such a positive global backdrop has renewed a belief in a “goldilocks” environment and, as such, the best-performing sectors have been those most exposed to the bullish global scenario.
However, the market seems incapable of looking beyond Brexit uncertainty when it comes to valuing domestic-facing companies, which are now heavily discounted by historic standards.
The UK property sector is just one area to have been stuck between a rock and a hard place over the past 18 months. The aftermath of the EU referendum was particularly turbulent for share prices, as analysts priced a technical UK economic recession into forecasts. This negative view of the world was then expounded into 20 per cent to 30 per cent share price slumps, giving rise to historic discounts to net asset values. The market has assumed a particularly cautious stance on the prospects for London real estate due to residual concerns around the city’s economy and the potential for a “Brexodus” event for financial services.
Among those worst affected has been Derwent London. Despite delivering earnings growth, strong letting volumes and an attractive development pipeline, it currently trades at a discount of over 20 per cent to NAV. London office space features prominently in Derwent’s portfolio, a segment which appears vulnerable to both structural and fundamental pressures.
London offices would likely suffer in the event of a financial services exodus but the impact may be more benign than the market has priced in. Financial services constitutes just 30 per cent of London office-based employment and has accounted for a fraction of job creation over the past 30 years.
Over 90 per cent of job growth during this period has been derived from professional services, creative and tech industries.
Activity in the direct market underpins the view that current discounts are unsustainable. Where UK property companies have been selling assets, they are achieving prices well above their NAV, suggesting the substantial discounts which have persisted since the referendum are catalysts for change.
Bucking the discount trend, Shaftesbury, Assura, Secure Income Reit and NewRiver Reit have proven resilient to wider pessimism and are trading at a premium to NAV. Of these, Shaftesbury’s broad-based portfolio in London’s West End has delivered good performance, supported by low tenant turnover and high-demand. A mix of restaurants, leisure and retail fulfils the trend for a more complete retail experience.
NewRiver Reit invests in retail properties located across the UK. The company’s convenience-led portfolio, affordable rents and active asset management continues to support income, underpinning one of the highest dividend yields in the sector. Despite recent data points indicating a continuation of current growth trends, strong consensus pessimism about the outlook for the UK economy continues to dampen valuations in domestically focused sectors, such as property, retail and support services.
While a materially improved domestic outlook may be unlikely, falling inflation and real wage growth should provide some respite for real incomes and, in turn, the revenues and margins of companies exposed to the UK consumer.
Sterling will continue to be a bellwether for confidence in the outlook for the UK economy. Since the referendum, economic growth has generally proven to be stronger than expected, prompting sterling to strengthen against global currencies. The pound continues to trade well below purchasing power parity, however, presenting considerable upside potential in the performance of domestic-facing companies, while further expanding disposable incomes.
Against a backdrop of continued geopolitical uncertainty, investors should proceed cautiously. But the UK market presents opportunities for profitable long-term investment in companies with the potential to deliver a sustainable flow of dividend income in the event of more volatile market conditions.
Mark Barnett is head of UK equities at Invesco Perpetual