It has been a frustrating year for UK equity investors. Just when the world economy seemed to be getting back on an even keel, equity market returns have gone sideways. Is it the beginning of the end of what has been good rally, or will patience be rewarded, as has happened so often in the past?
In our view, it will be the latter. We believe we are in a typical mid-cycle lull, similar to 2004 and 1994. After a couple of strong years, as we had in 2012 and 2013, the equity market will tend to pause before making further gains. The inflection point is usually, as now, when investors start to think about a change in monetary policy. With debates currently taking place in the UK and US as to when a tightening of interest rates will take place, there is understandable concern over whether economic growth will remain on course.
In respect to interest rates, the current historic lows are unlikely to hold indefinitely, and there is no reason that they should. Rates were pushed to these levels to cope with the aftermath of the financial crisis. It was a severe event and it has taken many years to work our way out of it. The authorities need to look forward. But even as economic growth settles in and we see a more positive environment ahead, there seems little to no urgency to raise interest rates, either in the UK or the US.
In the UK, whilst economic growth has picked up sharply, inflation is subdued, helped lower by a strong pound. There is no sign of a credit boom, and macro-prudential tools are likely to play a more important part in the UK housing market in the future than interest rates alone. Similar conditions prevail in the US, though the property market there is generally more subdued.
As investors become more comfortable with the view that interest rates will rise slowly and gently, other factors will come back into focus. In our view, there will then be two critical issues, corporate confidence and valuations.
On the first point, corporate behaviour will be critical to determining the strength and duration of the economic recovery given the relatively difficult financial positions of governments and, to a lesser extent, consumers. We know that companies are making good profits at the moment. We know they got cash, and a lot of it, on their balance sheets. What we need to see is the confidence among senior management to spend that money sensibly. We are starting to see early signs of that happening: for example, the amount of merger and acquisition activity is starting to pick up, both in the UK and the US. That is usually a good sign that management are confident about the future. We are starting to see better job creation. We have not seen a material pick-up in business investment yet, in terms of capital expenditure, such as plant and machinery, but to my mind that is coming as capacity is increasingly squeezed.
On the second point, valuations in the equity market also look reasonable, particularly in comparison with other competing asset classes, and this too is likely to provide a positive impetus to the equity market in due course. Looking forward, the price to earnings ratio is around 14 times, a sensible level on any medium-term basis. Whilst the market has made good progress over the last few years, this is still a reasonable starting valuation point, and if the economic expansion persists there should be good earnings growth to support future equity market returns.
There is much to be optimistic about for the next two to three years. However it has been a volatile first nine months of the year and that volatility may persist for a while yet. Once investors become confident of a continuing economic recovery, even with gradually rising interest rates, a combination of reasonable valuations and earnings growth should support further upward progress for the UK equity market.
Simon Murphy is manager of the Old Mutual UK Equity Fund