UK equity funds falter as Brexit deadlock and coronavirus fall-out fuel negative sentiment
Investors have punished UK equity funds with heavy outflows, as the government stretches out ongoing trade negotiations with the European Union.
Some UK equity fund managers say there needs to be the “certainty” of either a deal or no-deal outcome in order to see a recovery in UK stocks, and boost investor sentiment.
Between June and August, UK equity funds suffered their worst three months on record, with investors pulling a total of GBP1.2 billion from funds in this category.
The turmoil continued into September, which saw three UK-focused funds feature among Morningstar’s ten worst-performing funds of the month.
One of those funds was Ninety One’s UK Special Situations fund, which follows a value investing strategy, and fell by 7.7 per cent in September. One of the fund’s co-managers, Alessandro Dicorrado, says that the outlook for UK equities has been damaged by the economic hit from the coronavirus pandemic, but could look up if progress is made in ongoing Brexit negotiations.
“At the moment, there really are very few buyers [of UK equities]. When I speak internally to other fund managers, and when I speak to clients, the dejection and negativity I hear about the UK market is something I've never seen before. People are so quick to judge this market negatively.”
The UK has two more months before the status quo transition arrangement with the EU ends, and both sides are at an impasse over a way forward to firm up trading agreements, with neither party wishing to offer concessions over critical issues such as French fishermen retaining the right to fish in British waters.
Global money managers have positioned themselves near-consistently underweight in UK equities since the Brexit referendum in 2016, according to Bank of America Merrill Lynch’s monthly investor sentiment survey.
“There's an element of global investors just not wanting to bother with the economic uncertainty of the UK, which you can understand,” says Dicorrado.
Last week, Prime Minister Boris Johnson said trade talks were “over” and that there was “no point” in continuing negotiations, walking out of the European Council summit without a deal in sight.
Both sides say they want to strike a deal, but the EU says it will not do so “at any cost”, and the UK has set a deadline for the end of the year to have a deal, and says it will not continue trade talks next year.
“If you look at the way that the Brexit negotiations are going, we're either in a situation where the two negotiating parties are coming at this from completely incompatible viewpoints, or, if you ask people in the UK, they'll tell you that the government just seems determined to wreck the economy,” continues Dicorrado.
American investment banking and advisory firm Stifel wrote in a note to clients in October that a trade deal with the EU was the number one factor that could encourage a reversal of fortunes in the UK equity markets.
“There have been indications from the UK/EU trade negotiations that significant progress has been made either towards a full deal or at the very least a series of mini-deals. The reaching of a deal in the next few days or weeks would provide clarity for business and is likely to be helpful for the UK equity market,” write Stifel’s analysts.
Dicorrado agrees that it “would be better for everyone if we had a deal”, but adds that it may be just as important for there to be an end in sight, even if that means a no-deal outcome.
“Markets hate, hate, uncertainty. It's not so much the negative news itself that's important, it's the certainty or uncertainty around the news.”
Nick Little co-manages BlackRock’s UK Equity fund, which returned -0.6 per cent over the month of September. During this time, the FTSE All Share index fell -1.69 per cent.
He believes that the UK’s underperformance has less to do with Brexit, than it does to do with the economic fallout from ongoing coronavirus restrictions in the UK.
“The [trade] negotiations have been going on for a long time, so following the daily moves is not a key consideration when making investments.”
Little continues: “All investments are actually made on the basis of research into company and industry dynamics, and we feel that strong fundamentals are much more important than any macro narrative, including the final outcome of Brexit negotiations. So, in terms of Brexit outcome, we firmly believe strong companies and industries will prevail, regardless of the result of the negotiations."
He says weakness in the UK stock market has been caused by the “higher proportion of consumer and leisure facing companies”, which are the areas that have been most negatively affected by the ongoing coronavirus restrictions. “Increased innovation or an easing of restrictions could see this quickly reversed.”
Little adds that a rising tide may not lift all boats. “Separately, the UK stock market also has a high weighting in oil producers, and their share prices have fallen hard this year – as they have slashed dividends and face an uncertain path to transition away from oil production to a carbon-free future. These are much longer-term pressures that cannot be easily solved by an easing of coronavirus restrictions.”
The combined blows from coronavirus, uncertainty over trade with the EU, and dividend cuts has left UK markets looking significantly cheaper than other developed markets, with the FTSE All Share on a price-to-earnings (PE) ratio of 17.5x and the FTSE 250 Index on a 15.1x ratio.
The US index, the S&P 500, is more expensive, with a PE ratio of 27.7x, and European markets are between 20x and 25x.
Ninety One’s Dicorrado says that the value-focused UK Special Situations fund is in a good position to take advantage of low share prices in UK equities.
“Investing in times of extreme negative sentiment is not a bad thing. There are places where extreme negative sentiment is completely justified, since there are industries that are structurally declining. But historically, being able to take advantage of extreme periods of negative sentiment has paid off. Some people are just being quite rational about it and seeing that this is an area that has been left behind, and everything else is expensive.”
This was most evident during the coronavirus sell-off in the first two quarters of 2020, which Dicorrado says gave him the opportunity to “set the portfolio up for the next five years” thanks to stocks trading at attractive valuations. A recovery from coronavirus, raising cyclical stocks, is the “most likely candidate to lead to a value recovery” in the long-term, he adds.
Brendan Gulston co-manages the LF Gresham House UK Multi Cap Income Fund, which returned -0.8 per cent over the month of September. Gresham House is a boutique asset manager specialising in alternatives, with over GBP3 billion in assets under management.
“There has never been a better time to unearth undervalued gems in the UK market. With the UK out of favour, the pandemic has deepened the discount on offer for UK micro and small caps, which were already trading at vastly cheaper valuations relative to larger cap UK stocks and international earners,” says Gulston.
Gulston also warns that it is also a time to “differentiate the durable from the doubtful” and exit firms that have “a less visible path to recovery”, such as those that are reliant on higher consumer spending, and firms that have not yet reinstated dividends.
According to Stifel, UK equities have been dealt a blow by dividend cuts and suspensions, which have wiped out the “relatively historical high yield generated in the UK market” which has been “a support in the past”.
This has made it harder for UK companies to compete with markets like the S&P 500, which boasts a “significant number of growth/tech companies, which have been key drivers of performance in recent months”.
“We think if the corporate background was to improve and dividend suspensions were lifted, this could be helpful for the UK equity market,” continues Stifel.