The UK market – one of the world’s oldest – has spent five long years being unloved due to a host of factors. However, as these headwinds have begun to abate, cheap and alluring opportunities have been left behind. It’s certainly fired up the private equity dealmakers: UK plc has seen a tsunami of activity this year.1 This article explores why UK equities have been given the cold shoulder and how the receding headwinds have engendered a fertile hunting ground for Job Curtis, Portfolio Manager of the City of London Investment Trust.
Dragging us lower
The pain for financial markets began when Britain unexpectedly decided to leave the EU on 23rd June 2016. Investors dislike uncertainty, and the years of political infighting, protracted negotiations and broken deadlines that ensued fed a malaise against UK shares. Consequently, the pound tumbled, businesses froze investments fearing what a ‘no deal’ might mean for their futures, and Britain’s stocks have underperformed against other global markets since then (as highlighted by the chart below).2
Source: Bloomberg, 31/05/2016 – 30/11/2021
Then, Covid-19 descended and added to Britain’s woes. The UK would end up one of the worst affected economies, with demand hit by repeated rounds of strict lockdowns. Although strong fiscal and monetary policy were unleashed to contain the crisis, by the end of 2020, the economy had shrunk by nearly 10% year-on-year (the largest annual fall on record).3 For UK income investors, the outcome was certainly painful, with the UK market exposed to sectors badly affected by the pandemic. Profits and dividends were cut, with financials and oil & gas the worst affected sectors.
In particular, regulators forced banks to suspend dividends to preserve cash, even though many boasted healthy balance sheets going into the crisis. HSBC, for example, had the biggest dividend cut in the world, at $10.3 billion. Meanwhile, the energy sector suffered due to its sensitivity to economic activity, with big dividend payers such as Shell forced to cut, in this case around $10 billion.4 All-in-all, eye-watering cuts of 44% were made to UK dividends over 2020, including sharply lower special dividends.5 Given the UK market’s reliance on dividends as part of an investors total return, the UK underperformed European markets by around 20% and the US by almost 25% over the year.6
A positive response
All said, markets fluctuate, and the unwinding of several headwinds has turned around the UK’s fortunes. To begin with, Brexit uncertainty has been markedly reduced, after a deal was reached between the EU and the UK on Christmas Eve 2020 - a few days shy of the deadline. Suddenly, the trading environment for businesses is a lot clearer than it was a few years ago.
In dealing with Covid, strong fiscal and monetary responses have helped carry the economy over troubled waters. The government has managed to keep people in jobs and support businesses through policies such as furlough, self-income support, and businesses interruption loans. The Bank of England has also ensured that the money has kept flowing and borrowing remained cheap through quantitative easing (QE) and low interest rates, as shown in the chart below.5
Source: Bank of England, as at 21st Nov 2021
Perhaps most importantly of all, however: the NHS has masterfully handled the vaccine roll-out, enabling Britain to get ahead of most developed economies, and re-open quickly. As a result, widespread bankruptcies have been avoided, household savings are the second highest they have been on record, demand has returned strongly, and the economy has sprung back into action. Meaning the UK economy is set for one of the strongest years since 1973, with the Office for Budget Responsibility (OBR) forecasting GDP growth of 6.5% for 2021.7 In addition, Britain’s stock markets are looking alluring from several different viewpoints.
A turnaround indeed
First, UK shares look the cheapest they’ve been in decades. When looking at the price of UK shares relative to forward earnings and compared to global indices, an enormous valuation gap emerges – UK shares are trading at around a 40%8 discount to global shares (as highlighted in the chart below). This is quite remarkable given they were on par just prior to the Brexit vote in 2016.
Source: JPMorgan, as at 1st Nov 2021
Second, dividends have largely recovered. In the UK, total dividends are up 88.6%year-on-year to September 2021; and even if adjusted for things like currency movements and special dividends, they’re still up 59.9%.9 With balance sheets looking much healthier, and profits on the mend, the outlook for dividends looks encouraging.
In particular, there has been extraordinary growth in mining dividends off the back of soaring commodity prices and record-breaking profits. BHP – the world’s biggest dividend payer in 2021 - and Rio Tinto both sit on London’s exchanges. Banks, the other big Covid loser, have also rebounded strongly as regulatory restrictions on dividends have been lifted.9 It means the UK market’s dividend yield is now the highest of all regions globally, and far above rates on gilts or bank deposits.
Third, the weak currency offers a boost for UK firms, as many operate in global markets and derive a substantial portion of their revenues from overseas. 77% of FTSE-100 company revenues come from abroad, for example, and for the FTSE-250 it’s 58%.10 Analysts think the pound’s weakness is likely to continue into next year.
Promising market environment
This environment is particularly desirable for The City of London Investment Trust – a £1.75bn investment trust - managed by Job Curtis. The Trust aims to provide investors with long-term growth in income and capital, principally by investing in shares of UK companies, with a bias towards larger stocks on the FTSE 100. It is a mandate in which the Trust has delivered successfully, paying out 55 consecutive years of growing income to its investors. This unbroken record is one of the longest in the world, and why the industry body for investment trusts – the association of investment companies (AIC) – labels it as one of their ‘dividend heroes’.
The investment trust structure has also been crucial in ensuring that investors receive a stable and reliable income, due to its revenue reserve feature. This feature allows the manager to reserve surplus income during the good years and pay out in the leaner years, thereby smoothing the level of payments during periods when dividends are less plentiful; last year being case in point.
Performance has been understandably weak in the years following the Brexit vote and when the pandemic hit. However, it has shown a marked improvement since news of successful vaccine trials emerged a year ago, when economically sensitive stocks - of which the London market is heavily exposed to - rallied strongly as investors bet on a global economic recovery. Moreover, given cheap UK valuations, Job is finding a host of reasonably priced, strong dividend paying companies in which to invest. These include companies in the consumer staples sector, for example Diageo, Unilever, and British American Tobacco, which offer strong global growth prospects, especially in emerging markets; within the financials sector, where he believes the prospects for earnings and dividend growth are undervalued; and in food retailers such as Tesco, which offer strong cash flow generation and are looking cheap relative to history.
Exciting prospects ahead
As compelling as the UK seems, one must be cognisant of headwinds that pose a risk to markets and the global economy. The war on Covid rages on, as the emergence of the recent Omicron variant vividly proves – threatening the spectre of further lockdowns. Resource bottlenecks and labour shortages are also hobbling the economic recovery somewhat as supply chains struggle to meet resurging demand. Alongside soaring energy costs, it’s putting pressure on prices and wages, sending inflation sharply upwards. The OBR thinks the consumer price index measure of inflation could reach just shy of 5% next year, which would be the highest rate in three decades. It means the Bank of England may need to raise interest rates soon to cool inflation, and the government may need to tighten fiscal policy too, which could put the brakes on markets. That said, anxiety over the new variant means these decisions will likely be put on hold until next year.
Nonetheless, with valuations at decade-long lows, dividends largely recovering and set to be strong, and the weakness in the pound providing a tailwind for many UK companies, the opportunities in UK Plc and for the City of London Investment Trust are certainly looking encouraging.
- Source: KPMG: UK private equity activity soars - KPMG United Kingdom (home.kpmg)
- Source: Bloomberg, 31/05/2016 – 30/11/20211
- Source: Office for National Statistics, as at 12 February 2021
- Source: Janus Henderson Global Dividend Index – Edition 29, February 2021
- Source: LinkGroup, UK Dividend Monitor Q4, 2020
- Source: J.P. Morgan, as at 1st Nov 2021
- Source: Bank of England, as at 21st Nov 2021
- Source: Bloomberg, U.K. Economy Set to Grow 6.5% in 2021, Best Since 1973, Chancellor Says - Bloomberg There is no guarantee that past trends will continue, or forecasts will be realised
- Source: Janus Henderson Global Dividend Index – Edition 32, November 2021
- Source: Vanguard, The case for FTSE 250 exposure, as at 28 June 2021