Macro drivers have had a major impact on the UK equity market during 2016. Sector and stock performance has diverged wildly in response to sharp moves in bond yields and currencies. These influences have tended to favour share prices of the UK's largest stocks as investors chase the beneficiaries of low bond yields and the strong dollar.
This has opened up opportunities for investors willing to stay focused on company-specific fundamentals, including smaller and mid-sized stocks. In addition, there are some strong indications that sentiment towards markets may be approaching extreme levels.
First, the gap between equity dividend yields and bond yields has widened to record levels since the Brexit vote. This reflects anxiety regarding the reliability of corporate earnings and dividends. Investors are justified to question the dividend sustainability of many stocks whose tight dividend cover makes them increasingly reliant on debt and scrip dividends - but it is wrong to tar all stocks with the same brush. Investors willing to scour the market will find many UK stocks that offer the prospect of sustained dividend growth from a starting point of healthy dividend cover and low debt levels.
Investors should also question the sustainability of low bond yields in the environment of rising inflationary pressures and changing central bank attitudes towards quantitative easing. Indeed, investors seem to be flattering government bonds with the assumption of low solvency risk but punishing UK equities with the assumption of high earnings/dividend risk. This creates opportunities for active investors.
Valuations sharply diverge
Second, UK sector valuations are polarised and poised to snap-back. Macro-driven moves in bond yields and currencies have led to some extreme disparities in sector valuations. The gap between cyclical and defensive valuations is even higher than it was during the financial crisis of 2008-09. Low bond yields have pushed investors into sectors such as consumer staples, which now trade on valuations of around 20x PE with a 2-3% dividend yield, despite pedestrian organic growth rates.
Some investors continue to believe in the ‘greater fool' theory, relying on being able to sell their overvalued stocks at an even higher valuation in the future. Up to now this approach has worked well, supported by QE. So, what is the trigger for this strategy to backfire?
Let's get fiscal
In terms of sector performance, we would point to the potential for a shift in focus from monetary to fiscal stimulus as a potential game-changer. In this environment, we would expect cyclicals and financials to outperform, while bond proxy sectors should underperform. Brexit has been a wake-up call to global policymakers as it demonstrated the risk of popular discontent. The shift towards fiscal policy would help politicians to show that they are in touch with the electorate - and potentially drive a rebalancing of the economy and markets.
Monetary stimulus drove down bond yields and therefore led to the outperformance of bond proxies over cyclical and financials. However, we are now seeing increasing evidence of the real world pressure that QE is causing on savers, pension fund deficits, insurance companies, banks, etc. At the same time, central banks' options are running out as the stock of purchasable government bonds diminishes.
It's all about fundamentals
The other trigger for a change in sector performance is recognition that underlying corporate fundamentals do not justify either the underperformance of cyclicals and financials or the outperformance of bond proxies. Management commentary of UK domestic companies remains buoyant post-Brexit, supported by solid UK economic data. Initial fears of a sharp drop in activity are looking misplaced. Consumer sentiment remains positive and household cashflows look set to hold up despite the weak pound, as wage growth and lower interest payments offset higher import prices. Against this backdrop, domestic cyclicals and financials therefore look ripe for a recovery.
In summary, the UK equity market appears to be at an extreme in terms of macro-driven positioning, creating opportunities for bottom-up investors willing to stay focused on company-specific fundamentals. We continue to use our extensive research resource and Focus on Change investment process to identify companies which we believe have sustainable dividend growth, and where attractive dividend yield is backed by cashflow momentum, dividend cover and balance sheet strength. We remain confident that this approach will deliver superior growth in capital and income over the medium term.