Richard Buxton, Head of UK Equities, looks ahead into 2011…
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– Corporate profits have been the bright spot of the recovery
– UK stocks remain relatively undervalued and have the potential to rally significantly in 2011
– We will not rollover into a double-dip. The private sector will absorb public sector job losses
By the beginning of 2010 we had seen almost straight line growth in equities since the March 2009 nadir. History tells us that straight lines are followed by sharp corrections, and this time was no different. The onset of the Euro-sovereign debt crisis brought the rally fuelled by the recovery and the apparent success of quantitative easing back down to earth with a bump. Heightened uncertainty led investors to become evermore reactive to short-term news, and whipsaw volatility in equity markets ensued. However, amid the storm there was a constant – improving corporate profits. The de-rating of shares ignores the vast improvement in company fundamentals, and it is our belief that into 2011 the absence of a slide back into a ‘double-dip’ recession will encourage companies to be more optimistic, which will feed through via increased capital expenditure. In short, UK equities have the potential to rally significantly in 2011.
Why do UK equities present such attractive opportunity?
We can expect UK equities to rise as much as 20-25% in 2011. It is a paradox that the worst recession of a generation has made the UK one of the most attractive areas for investors today. Having shed jobs quickly at the beginning of the recession, companies are now leaner. Moreover, strong profits this year leave companies cash rich – cash which is currently on the sidelines. The market continues to discount a highly uncertain outlook, though as companies realise that we are not headed for a double-dip, capital expenditure will rise. We expect the recent pick-up in M&A to become more prevalent; currently mothballed projects to be put into action; and hiring to resume. On a global basis, UK stocks remain relatively undervalued and offer strong recovery potential, dividend yields are growing, and although the UK may just be a small market, listed companies have a truly global reach. These factors combined make the UK a very attractive market for investors.
Company fundamentals are much improved Corporate profits have been the bright spot of the recovery.
UK profits will be up around 50% in 2010. This is a remarkable achievement, given what has been a fairly anaemic recovery so far. The figures are testament to the hard fought restructuring which businesses engaged in during the early stages of the recession. The results are clear: many companies now enjoy improved balance sheets, streamlined costs and better cash generation. Investors have been focused on the potential for the weak economic environment to drive down the profits of businesses because of the operating leverage inherent. Costs are fixed, sales are variable, and profits collapse. But one of the things that investors haven’t been focusing on is the fact that this can, and indeed does, work in reverse. Businesses have done a sterling job of taking out costs and, as sales come back, there will be a leveraged improvement in profits. Evidence of this can be seen today, and in the medium to long term, the level of profit that businesses can generate can still move ahead significantly in excess of what they have generated in the last 12 months. Companies are generating record cash flows, and enjoying record profitability, yet investment is at record low levels. Now we must see that cash put to work.
How will fiscal austerity affect the market?
Following the Emergency Budget in June, investors were nervous about the impact of the Comprehensive Spending Review. Fears were focused on outsourcing and infrastructure companies, given the risk that the spending squeeze will hit new capital expenditure and, in turn, earnings. In fact, the cuts revealed were not as bad as the market expected, which should be good news for companies exposed to these areas. Of course spending cuts will have an impact, and for businesses there will be both winners and losers. However, though public spending in real terms is set to fall, the efficiency reviews that will undoubtedly follow will present opportunities for smaller, leaner and meaner companies to win new business. In addition, where the state is reducing its involvement, it presents new opportunities for private sector solutions. Historically, there is a strong inverse correlation between PE ratios and Government as a percentage of GDP. When the government is expanding as a percentage of GDP, the equity market de-rates. When it is shrinking as a percentage of GDP the market re-rates. We expect the market to follow this pattern.
Risk of a double-dip?
We hold the view that the UK will avoid a double dip – a conviction supported by the upside surprise for third quarter GDP. Fears that the private sector cannot offset the reduction in the public sector are overdone. The chancellor confirmed the 490,000 public sector job losses as forecast by the Office for Budget Responsibility (OBR), but given that the economy added 323,000 private sector jobs in the first half of 2010, we are confident that the economy can not only absorb the public sector job losses, but also bring down unemployment. Job creation is vital to a sustainable recovery and, although inevitably there will be bad months over the next year the private sector labour market will, because it is so much bigger than the public sector, absorb public sector job losses. Importantly, it is not the level of unemployment that affects consumer spending; it is the fear of unemployment. We believe this fear is likely to recede next year. We are not expecting a buoyant consumer environment. Indeed, we are likely to see very sluggish growth in the UK as households continue to deleverage, but we do not believe we will see the rollover into a deep consumer recession as is currently priced into many areas of the UK stockmarket.
Beyond the UK, the picture is also encouraging. In the US, the labour market is showing signs of further improvement, with the latest employment numbers almost triple expectations. Anticipation of QE2 from the Federal Reserve (Fed) was supportive of equities. With the cards now on the table, it is clear that the Fed is willing to do what it takes to avoid deflation, boost demand, and avoid a double-dip.
The views and opinions contained herein are those of Richard Buxton, Head of UK Equities, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
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