There is no denying UK equities have endured a difficult decade. An investment in the FTSE All Share Index ten years ago would have delivered an annualised total return of just 4.8% compared to average inflation of 3.2%, according to Bloomberg. As a result equity investing is currently out of favour with UK pension funds, who have decreased their holding of equities, predominantly in favour of liability-matching bond portfolios.
Valuations reflect this shift; the dividend yield of the FTSE All Share Index (3.8%) has risen above the yield of 10-year gilts (2.0%). The ratio of the equity index’s dividend yield to the bond yield is close to its long term historical high, and certainly much higher than it has been for more than 50 years.
The economic policies of the next decade are already being shaped by the experiences of the last, and this has implications for equity investors. There is a fear of a depression resulting from excessive personal, corporate and public sector debts. This and the catalyst of the credit crunch have led to economic policies in the developed world which accept higher inflation and attempt to stimulate demand through government spending, low interest rates and the monetisation of debt.
The pursuit of growth at higher levels of inflation is a major change in outlook. Will this be a major tailwind for equity investing? This remains to be seen, and depends upon the relative strength of the inflation hedge in companies’ nominal profits compared to the de-rating effect of a higher cost of equity as inflation expectations rise. What is clearer is that greater levels of economic and political uncertainty and higher levels of inflation combine to create a tougher playing field for companies, and we expect this to lead to a greater differentiation between winners and losers.
What winners look like
Corporate earnings growth will be harder to deliver. This is due to a combination of the generally low GDP growth outlook combined with cost pressures arising from general inflation. Companies with poor financing or a marginally competitive product will face greater headwinds through constraints on banks and bank lending, weaker demand as the real purchasing power of customers declines, and rising input cost pressures. We also expect companies to find external finance more costly, and therefore a greater differentiation between well financed and poorly financed businesses.
The positive side of this situation for investors is that we can expect a divergence in reported profits i.e companies reporting growth in profits versus profit warnings – and a consequent divergence in company returns. Good companies with sensible strategies and strong balance sheets will be able to continue executing their business plans, and this is likely to be at the expense of competitors. Quality franchises should outperform through being able to demonstrate margin protection, good cash generation and the ability to reinvest to generate superior returns and dividends for shareholders.
At the same time, valuations of the shares in these “winning” businesses are not substantially differentiated because investors are focused on the general volatility of financial markets that results from this uncertain environment. Hence the opportunity for investors: winners are under-priced, and the field is tilted in their favour.
Nick Little, CFA, Director and a member of the BlackRock UK Specialist Equity team.
