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Newton shows optimism on UK equities

Newton UK income portfolio manager David Cumming explains why he is optimistic on the prospects for the UK equities market.

Key points:

  • Investor demand for UK equities has fallen significantly over the past 30 years.
  •  But inflation is falling and interest rates appear to have peaked while risk from global conflicts has been largely discounted by markets.
  • Newton thinks UK equities look cheap relative to history and relative to the US market.
  • UK dividends look attractive relative to gilt yields, according to Newton.

At a time when most people appear to be deeply gloomy about UK equities, Newton portfolio manager David Cumming is optimistic on prospects for the asset class.

The UK market has had a tough time over the past 30 years. Demand for UK equities has fallen significantly over that time as asset owners such as pension funds and insurance companies have sought returns and income from other asset classes.

Ownership of UK equities by pension funds and insurance companies dropped to 4.2% in 2022, from 45.7% in 1997. Pension funds alone held just 1.6% of the UK stock market in 20221. Meanwhile, more than two thirds of UK shares are owned by foreign groups2.

“There has been a marked decline in [UK equity] ownership and it does signal the UK equity market, at least in its own country, is unloved,” Cumming adds.

But despite the gloomy consensus, Cumming outlines several reasons why he thinks the UK market’s prospects are bright.

Inflation

First, Cumming says it is clear UK inflation is falling. The contributions of energy and food to the overall CPI figure are moving negative. Cumming thinks UK inflation will fall below 3% in 2024.

Interest rate expectations

Cumming believes that UK interest rates have peaked. He adds interest rate expectations have started to come down as the supply shock to inflation has diminished. This is evident through falling gas and electricity prices, he says. Bond yields have already fallen, and interest rate cuts should follow in the second half of this year, adds Cumming.

Geopolitical risk

Elsewhere, Cumming says while geopolitical risk remains elevated, the impact of the two ongoing conflicts have been discounted by markets. He notes the conflicts now have little impact on key energy components, and with plentiful oil supply available energy prices are modestly skewed to the downside.

Economic outlook

Cumming also says news flow on the UK economy has been resilient, even positive at times, noting the Bank of England Monetary Policy Committee’s real GDP projections have steadily risen over the past year. The Newton UK income team is not expecting a UK recession in 2024.

Cheap market

UK equities are cheap relative to history, says Cumming, especially compared to the US where a handful of tech companies have led the market. He adds the quality of UK price to earnings (P/E) is good, with financials and industrials looking well capitalised compared with 2008/9 with decent solvency ratios, dividend cover and low levels of debt, he says.

“Even if you adjust for the emergence of tech and you are wildly optimistic on artificial intelligence (AI), on a sector-for-sector and stock-for-stock basis, we think UK stocks are significantly cheaper than their US counterparts,” adds Cumming.

Dividend growth

Cumming is not expecting UK dividends to be cut in 2024, observing dividend cover is high and balance sheets are solid. He says the market is expecting dividend growth of about 7% in 20243 with key sectors being oil, financials, and industrials. “I expect dividends to continue to move ahead, albeit in a slow economic environment,” he adds.

Cumming thinks UK equities look attractive to UK gilts particularly if you think dividends will grow from here. Despite the rise of bond yields over the past year, he says 12-month forward UK dividend yields are sitting close to five and 10-year bond yields.

“If we are going into a quantitative tightening (QT) world rather than a quantitative easing (QE) world, it would make sense that the market feels a little bit more comfortable with equity dividend yields slightly below bond yields,” he adds. “The big difference is dividend yields should grow from here whereas bonds don’t give higher yields in terms of payments.”

Positioning

“We are optimistic, and the strategy seeks to be positive in terms of economic positioning,” adds Cumming. This view translates to an overweight in the portfolio to industrials, basic materials, and energy, and an underweight in consumer staples, defensives, utilities, and telcos.

“We are trying to take a positive view in terms of economic sensitivity,” adds Cumming. “We are looking to position ourselves to outperform a rising market. We expect economic conditions and the market outlook to improve this year, so we want to benefit from that.”

Overseas exposure

The Newton UK income strategy can invest up to 20% overseas which, Cumming adds, can improve the strategy’s liquidity, and allow the team to buy attractive stock alternatives to those available in the UK.

The strategy has significant exposure to continental Europe which, Cumming says, is largely because the team views the US market as expensive. In Europe the team sees relative opportunities in healthcare, media, and insurance.

1 The Telegraph. Pension fund ownership of UK stocks hits record low. 4 December 2023.

2 Haver Analytics, Goldman Sachs Global Investment Research. October 2023

3 Lazarus Economics, November 2023.

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