By David Winckler, Senior Investment Analyst at IBOSS, part of Kingswood
Amidst all the doom and gloom last year, it was refreshing to see the FTSE All Share outperforming world equities by a sizeable 7%. The UK was the only major equity market to deliver positive returns, albeit a meagre 0.3%. High commodity prices and a weaker Pound were certainly supportive for UK equity performance given the global nature of the index and its large exposure to energy and material sectors. Yet, UK fixed income had its worst year on record.
This time last year, the macroeconomic environment was somewhat different. Business confidence was relatively positive, the economy was growing, and the market expectations of a Putin invasion into Ukraine were next to nothing.
Putin’s war exacerbated the global inflation problem, especially for the UK which was already dealing with the knock-on effects from Brexit. Couple that with three different Prime Ministers and Chancellors of the Exchequer in 2022, it was unsurprising that the pound weakened 11% and conventional government bonds lost a whopping 24%.
Most equity and fixed income markets around the world experienced losses of a similar magnitude due to unexpectedly high inflation and intensifying recessionary risks. In fact, the correlation of asset classes was unusually positive and almost everything, other than UK equities, lost money in 2022.
The good news is that UK assets are more attractive today than they were at the start of 2022. Both equities and bonds are considerably more appealing on an absolute basis and equities should also outperform on a relative basis.
With a yield of around 3.5%, 10-year UK Gilts now generate a fair degree of income and also offer some protection in risk-off market moves. We had and still have little exposure to Gilts as they are too volatile and far from being “risk-free” assets. On the other hand, we like the investment grade UK credit market because company fundamentals remain robust, and yields are attractive (particularly banks which are far better capitalised than they were in the Great Financial Crisis). Moreover, our use of active fund managers in these markets means we are mainly exposed to high quality bonds with reduced downside risks.
The UK equity market trades at a forward Price/Earnings ratio of around 10x, levels which were last seen in 2012 and during Covid. It is 30% cheaper than the rest of the world, mainly because of higher valuations in the US. With the probability of recession largely priced in, the economically sensitive smaller companies look relatively attractively valued and could outperform significantly.
To conclude, the macro environment remains challenging, but markets have already discounted most of the bad news. As the Brexit hangover fades and with some political stability (long may it last!), most UK assets look set to deliver superior risk-adjusted returns over the medium term.