The UK market’s turbulent start to 2016 has not come as a surprise. Heading towards the end of the last year I noted the near-term outlook for the market appeared challenged.
Valuations were not cheap enough in many areas, given the risks, namely the lack of earnings growth, potential monetary tightening in the US, the impact on emerging markets of a stronger dollar and the disruption caused by weak commodity prices, particularly oil.
The stockmarket has managed a good recovery from the post-crisis low in 2009 and the eurozone issues in 2011. However, the progress of corporate earnings in aggregate has been disappointing and there are questions over growth potential this year and beyond.
The stagnation of the FTSE All-Share level during 2014 and 2015 suggests investors are unwilling to apply a higher PE ratio to equities until they see better earnings growth potential in a low inflation world. With producer prices in decline it is not obvious this is guaranteed.
I believe the stockmarket will continue to reward visibility of earnings and am looking to holdings in areas such as tobacco, support services, fixed line telecoms and life insurance to demonstrate these characteristics. This year is also likely to be an important one for pharmaceutical companies and I am hoping for further progress on new drug development from AstraZeneca and Roche, as well as from smaller companies.
I am not a big fan of pure price-taking industries (and do not hold any mining shares at present) but the current weakness should trigger a big retrenchment in supply, allowing markets to rebalance and prices to recover eventually as higher cost production is eliminated.
Oil, being a consumable product, displays relatively robust demand characteristics. The supply increase instigated by Saudi Arabia in 2014 has led to the current price collapse and the industry is now slashing future investment plans. So, once the excess inventories have cleared, we should return to a price regime more in line with the true marginal cost of new supply. We can debate what that is but it is materially above current levels.
In addition, the major oil companies can, within reason, adjust their operating and capital costs (much of which is outsourced) to deliver acceptable returns at lower prices and pay dividends. I see BP as the cleanest way to capture such a recovery but this will be relevant to other energy related stocks such as Centrica, Drax and SSE, all of which have been affected by price weakness across the whole energy complex.
Outside commodity sectors, we have seen weakness in banks. I do not currently hold any mainstream banks in my income portfolios as I am not convinced the more bullish assumptions about dividend progression will be met. Elsewhere in the financial sector, however, I have found plenty of opportunities in areas such as insurance, speciality lending and property.
At current market levels I am happy to add to most of the holdings in my portfolio, predominantly pharmaceuticals, tobacco, support services, telecoms, defence-related companies and various financial services.
I do believe returns in the oil industry will recover but I do not envisage a wholesale reversal of the current disinflationary trends that prevail in the world economy and are making top-line growth hard to find in many sectors.
Mark Barnett is head of UK equities at Invesco Perpetual