Time to reassess UK equity valuations

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The near-term outlook for the UK equity market is likely to continue to be dictated by the movement of global bond prices and the sterling/US dollar exchange rate. These asset markets have exerted a major influence over the course of this year.

Indeed, the strong performance of the bond market (which, unusually, has been accompanied by a rising equity market) and the perceived benefit from the drop in sterling have been the driving forces behind its ongoing re-rating.

As we approach year-end, this valuation looks full, particularly relative to the disappointing overall level of underlying profit growth recorded this year (excluding the impact of sterling and the commodity bounce back).

With bonds and equities rallying, and central banks stepping up their activity, there is a nervousness in the market. It is highly unlikely that the re-rating of UK equities will continue unchecked against a backdrop of higher valuations and ongoing pressure on corporate profitability, and there has been a noticeable pick-up in the rate of profit warnings over the recent period.

Challenges ahead

Looking ahead to 2017, there are several challenges that may force a reassessment of the current valuations being applied to the UK equity market.

The first is the lack of overall profit growth, which, absent a significant devaluation in sterling, would have seen another year of no growth in 2016. The underlying earnings outlook for next year looks similarly muted.

Second, a more difficult near-term UK economic picture is likely to emerge. Alongside the Bank of England’s fiscal package, the Treasury is considering all options to avoid recession: additional measures around corporation tax, National Insurance contributions and long-term infrastructure projects are all on the table.

The reappearance of inflation — largely as a result of the movement in sterling — will pressurise consumer budgets and hinder overall levels of economic growth. This factor, coupled with the ongoing uncertainty over the political path to Brexit, may put a brake on UK employment levels and investment intentions, further moderating activity in the domestic economy.

To some extent, this has been priced into equities already, as the performance disparity between globally and domestically exposed companies since the EU referendum has been significant. Nevertheless, the backdrop to corporate profitability is unlikely to ease over the coming year as pricing power remains elusive.

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Meanwhile, the political environment has the potential to deliver more surprises over the coming year; another factor likely to continue to exert major influence on both corporate behaviour and stockmarket performance.

The domestic political scene is currently overshadowed by the new Government’s evolving agenda, while internationally the implications of Donald Trump’s victory in the US presidential race and a series of other important upcoming elections need to be addressed. The potential for a sudden policy shift or another unexpected result is significant.

The final challenge is the pace and extent of a shift in the value of global bonds, which also has the potential to pressurise the outlook for positive returns from UK equities. Such a shift could result from a change in US interest rates or simply from a realisation that the extreme low yields reached over the summer months across the world no longer represent a realistic view of the medium-term outlook for inflation and interest rates.

Valuation vigilance

Navigating any one of these obstacles, either individually or in combination, will be challenging and the most important discipline is to remain vigilant about valuation.

Notwithstanding the elevated level of stockmarket valuation, bottom-up opportunities for the long-term investor have started to emerge as a result of the substantial sector rotations that have occurred since the Brexit vote.

Where new bottom-up opportunities arise, emphasis should be on companies that can demonstrate a sustainable top-line growth and translate that into profit, free cash flow and dividends, without excessive financial leverage.

Mark Barnett is head of UK equities at Invesco Perpetual