The UK's global
The principal attraction of the UK equity market is that it is one of the most international in the world. We estimate that around 75% of the revenues of UK quoted companies come from overseas and so an investment in the UK equity market is an investment in the global economy.
The leading position of London as a centre of international finance ensures that many of the leading companies in the world are listed in London. Royal Dutch Shell, BHP, GlaxoSmithKline, HSBC, British American Tobacco, Diageo and Unilever are just a few examples of globally market leading companies that are listed in the UK.
For investors with a medium term outlook, UK equities are undeniably attractive, especially when compared to the main investment alternatives of cash and bonds. The current Earning Yield of the UK Equity market is about 10% (inverse of a PE Ratio of 10 times). This compares with a Yield on the UK 10 year Gilt of 3.6% and an interest rate on 1 year savings of around 2.5%. This relative premium of equities over bonds has only been higher once in the last 50 years and this was in the dark days of the credit crunch in early 2009, when many people were concerned about a collapse of the global financial system.
Shorter term returns are more difficult to predict. At the beginning of 2011, we had a year end target for the FTSE 100 of 6,800, which would have been a return of 15% over the year. This target was based on a further year of earnings growth, but not on a wider rerating of equities.
However, the combination of recent events in the Middle East and Japan have increased downside risk to this target, primarily as a result of higher energy prices. These higher costs for both corporates and consumers could impact the still relatively fragile global economic recovery. Historically, sharp increases in the oil price have preceded economic downturns, and whilst it is still a bit too early say for certain that this will be the case in 2011, it is undeniable that the risks have increased. Our hope, however, is that the current scale of unrest in the Middle East will reduce and this would allow the market to attain our target.
The events in the Middle East are not the only risks on the horizon. China’s economic expansion over the last 20 years is unparalleled in modern economic history and managing this level of growth will not be easy. China’s economy is still heavily reliant on investment at around 45% of activity, with consumption a comparatively low 20%. This compares with the US, where consumption is 70% of the economy.
China has a plan to broaden out it’s economy in the medium term and make it less reliant on state investment spending, and there are risks that the Chinese authorities make a misstep and either allow bubbles to emerge, i.e. housing, or tighten too quickly, choking off demand for global goods and services. To date, progress has been encouraging, with action taken in the second half of 2010 going a long way to assuaging fears on a property bubble, but this is likely to be a multi-year concern and could keep a lid on equity valuations globally. The reason that China is so important to the global economy is that they are the largest consumer of many commodities and services in the world and in many cases the majority of incremental growth.
The second key risk remains high levels of Debt, mainly in developed economies. In some countries the debt lies at the Government level (US), in some it lies within the banking sector (Spain), whilst in some it is still at the personal level (UK). Many countries, including the UK, have a potentially unsustainable level of debt and the cost of this debt will only grow if interest rates rise. Repaying this debt is likely to be a drag on developed market growth for many years to come. In addition, the debt overhang is a key source of systemic risk and is another reason why equities may struggle to rerate to historic levels.
We retain a bias to Asia within our portfolio, given the region’s better economic prospects. This is reflected in our overweight position in the engineering sector. The UK engineering sector is a who’s who of globally leading growth businesses and we currently have three holdings, Weir Group, Rotork and IMI.
We also have a preference for emerging market consumer companies over developed market ones given the above comments on debt. So we have zero exposure to UK general retail or leisure, with our principal consumer holdings being Unilever and BAT, which have the majority of sales from emerging markets.
We are currently cautious on the UK banking sector due to our ongoing concerns about Government and Personal indebtedness. We believe the banking sector will lag the overall UK economy and certainly the global economy in term of growth as a result of the required deleveraging. That said, everything has a price, and we are constantly re-evaluating whether these risks are more than discounted. For the moment, our principal Bank holdings are therefore the emerging market-focused HSBC and Standard Chartered.
Finally, we believe we have the right team of people to manage the blend of risk and opportunity. The UK Equity Team at Alliance Trust is unusual in its focus and experience. The four members of the team have over 60 years portfolio management experience and are dedicated to one common strategy, which is unusual by industry standards.
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