After a year of extremes and the unexpected, the road ahead for UK equity markets looks uncertain. While forecasts of systemic financial disruption as a result of the EU referendum have proven largely unfounded, the decline in sterling and UK government bond yields following the vote triggered significant rotation across sectors.
Companies perceived to have a high degree of exposure to a potentially weakened economic outlook were hit hard. Diminished confidence in the UK property market, economic growth and the potentially negative impact of the formal Brexit process weighed on the share prices of real estate, insurance and financial services companies, in particular.
But while marked down heavily since the vote, companies such as Shaftesbury, Derwent London, Legal & General and Provident Financial actually fulfil the characteristics investors should look for. These include an ability to adapt and grow in a shifting regulatory landscape and to embrace new trends and technology.
The share price recovery of many real estate companies since the vote has been muted. But with limited evidence of property values in a post-referendum hiatus on transactions, the scale market’s de-rating of the sector seemed unwarranted. Real estate investment trusts Shaftesbury and Derwent London both sold off sharply, providing savvy investors the opportunity to top up holdings at a much lower price (see chart 1).
Shaftesbury commands a near-unique portfolio in the heart of the West End, with almost 14 acres spread across the high footfall areas of Soho, Charlotte Street and Covent Garden. Shaftesbury’s broad-based local economy should provide some resilience in the event of a softening in economic growth and consumer spending. The diversity of tenants – a mix of restaurants, leisure and retail – fulfils the rising trend for a more complete retail offering, experienced through distinctive destinations and a range of activities. The company aims to deliver total shareholder return via rental growth, currently underpinned by low tenant turnover and high demand.
Office specialist Derwent London’s recovery has been muted by concerns over future rental growth in London commercial property. However, the company set a new record for lettings in 2016 (with deals to the end of September surpassing the full year in 2015) and has several major developments in its pipeline, among them the Brunel building in W2, which should benefit from the development of the Paddington area ahead of Crossrail’s launch in 2018.
Consensus anticipates the election of Donald Trump in the US will give rise to a more reflationary period driven by tax cuts and, possibly, a boost to spending on infrastructure.
The immediate response has been a marked rise in long-term bond yields and inflation expectations, a trend that had already begun. In contrast to 2015, the Federal Reserve may be more determined to keep hiking short rates in response, which has boosted the US dollar against most currencies. Yields in the UK have followed suit to an extent.
One beneficiary of the steepening yield curve is Legal & General. A casualty of the post-Brexit sell-off, L&G’s shares have risen 50 per cent from its summer lows (see chart 2).
The group continues to dominate the UK retirement market. In November it announced the completion of a £1.1bn pension buyout, the largest bulk annuity of 2016. In an environment of rising bond yields, more companies will lock into more favourable conditions for de-risking their pension obligations; just one factor supporting the company’s long-term performance prospects.
Despite the dramatic slump in the share prices of UK major banks, I have maintained my zero weighting in these businesses. The regulatory outlook remains challenging, an additional headwind to their ability to pay and grow their dividends.
Provident Financial has many similarities to a bank. It can take deposits, has a banking licence and lends money to consumers. It also stands to benefit from a rising interest rate environment. However, a number of unique selling points differentiate its income-generating abilities from the mainstream banks.
It has built up a dominant market position in non-standard lending over many decades, which affords it superior pricing power. Its smaller size, UK focus and relative simplicity provide good visibility of the long-term earnings and dividend growth outlook, further supported by a strong management team. Its share price has risen 35 per cent from its post-Brexit low (see also chart 2).
The trend for large percentage moves in individual share prices and sectors in response to short-term forecasts or perceptions of long-term resilience looks set to continue. Investors must remain alert to new opportunities.
Mark Barnett is head of UK equities at Invesco Perpetual