The Standard Life Investments UK Equity Income Unconstrained Fund
Views from the fund manager
The dominance of macro drivers in 2016 has caused sector and stock performance to diverge markedly. Two key themes stand out: sterling and bond yields. In the short term, these have overwhelmed underlying dividend trends, causing share prices and dividends to de-couple. Nonetheless, this is likely to prove temporary as investors gradually shift their focus from macro drivers back to the underlying corporate fundamentals that underpin share prices.
The consensual view of slow growth and lower-for-longer rates had encouraged many income investors into bond proxy sectors. This process reached its climax after the UK's EU referendum, when investors herded into overseas consumer staple stocks. As bond yields have subsequently reversed course, the valuation support for these bond proxies has unravelled. Our approach throughout this period of macro noise has been to focus on identifying attractively valued companies with strong dividend growth profiles.
A strategy of exclusively owning overseas earners and bond proxies would have paid off handsomely in the first half of 2016, but this strategy has faltered since July as these stocks have sold off.
Recent events have caused a sharp reversal in investor positioning as consensual views have been called into question. Following the Brexit vote and Donald Trump's election victory, investors are starting to price in a combination of looser fiscal spending and a withdrawal of ultra-loose monetary policy. The losers from this have been bond proxies, with the winners being financials and cyclicals.
Furthermore, stocks with large pension fund deficits are now viewed in a different light as expectations moderate over the scale of the challenge. The potential for rotation applies to currency markets as well as sectors. Sterling had sold off aggressively on the view that Europe could play hardball with the UK in its exit negotiations.
However, the possibility that a variety of countries, such as the US or Australia, might provide the UK with alternative trading partners could help ease the UK's negotiating position with the EU as it triggers Article 50. Meanwhile, the Bank of England has signalled it will look through the inflation upturn expected into 2017. This has helped bolster sterling and mid-cap stocks.
For me, two factors - valuations and corporate fundamentals - point to the recent sector rotation gaining traction. Valuations had become polarised after the vote, with the gap between domestic and overseas earners at its widest point since 2008. Sterling's decline was well priced in - both in the premium on overseas earners and the discount on domestic stocks. At the same time, bond proxies had become favoured stocks. The valuation gap between value and quality had widened to new record levels, with quality stocks ‘priced for perfection'.
From this point of extreme sentiment in early July, there was a lot priced into fundamentals. As the spotlight shifted back onto corporate fundamentals, surprises started to drive share prices in unexpected directions. Bond proxies sold off and domestic stocks caught a bid. The results season provided a reality check - disappointments from highly valued, bond proxy overseas earners had the effect of deflating their lofty valuations. Examples of this included Unilever, Reckitt Benckiser, Smith & Nephew and Pearson. Investors buying these stocks purely on the grounds of favourable exchange rates were left disappointed.
Domestic concerns overdone
In contrast, many UK domestic earners appear to have beaten expectations, providing the catalyst for a valuation re-rating from very modest levels. Many of these, such as housebuilders, construction companies and lenders, were deeply unloved immediately after the EU referendum. However, initial fears of a sharp drop in UK economic activity appear misplaced - most economists were predicting an immediate collapse into recession in the third quarter of 2016. This is now looking far-fetched. Consumer sentiment remains benign and household cashflows look set to be supported by the strong labour market, wage growth, higher personal allowances and lower interest payments. This should largely offset higher import prices. Against this backdrop, the savage de-rating of domestic-earning stocks looks overdone.
The severity of the move underlines investors had been positioned too bearishly towards financials, cyclicals and UK domestic-earners, and too bullishly towards defensive bond proxies and overseas earners. Arguably these have been the ultimate macro-driven markets. Our approach in such markets is to stick to our process - using our resources to identify underappreciated stocks with the potential to deliver double-digit dividend and capital growth, rather than trying to second-guess swings in macro sentiment.
While macro drivers can be important influencers of share prices in the short term, they cannot disguise underlying fundamentals over the medium term. Ultimately, share prices will be driven by the trajectory of cashflows and dividends, providing an opportunity for investors who remain focused on corporate fundamentals.