Jonathan Marriott, Chief Investment Officer
As I write, the FTSE 100 Index is down 20% this year and, even accounting for dividends, it is still down 18.4%. The Euro Stoxx index of European equities is down 11%. Meanwhile, the US-based S&P 500 has made a positive return of nearly 5% in the same period. A huge dispersion of returns.
The Bank of England's revised outlook for the UK economy this week shows they expect a decline of 9.5% (adjusted down from 14.5% in their previous forecast). However, they see a slightly slower recovery, expecting GDP to be back to 2019 levels only by the end of 2021. Rishi Sunak's Coronavirus Job Retention Scheme has so far helped prevent a steep rise in unemployment but, as this unwinds, unemployment will rise and the Bank sees unemployment reaching 7.5% at the end of this year. All these predictions are of course caveated with words about the uncertainty around the progress of COVID-19. The UK economy is heavily dependent on the service sector, which has been hit hard by the pandemic, but this bias is not reflected in the FTSE 100 Index.
The FTSE Index is based on market capitalisation of the largest equities listed in London. These are mostly international companies with overseas activities, rather than dependent on the UK economy. The S&P 500 performance has been led by the tech sector, which now makes up 28% of the index. This sector has been less impacted by the pandemic and the move to working from home and shopping online has in fact helped many of these companies. Whereas tech makes up just 1.5% of the FTSE 100, materials and energy, which are more economically sensitive, account for 22% of the FTSE, compared with just 5% of the S&P 500. Therefore, the relative performance is more due to sector biases in the index composition rather than the local economy.
Despite the international composition of the UK market, it has been shunned by international investors given the continued uncertainties surrounding Brexit. This remains a concern with negotiations apparently going nowhere. The next round of talks starts on 17th August, with European Union leaders urging the UK to take a more flexible and pragmatic approach. However, there appears to be little room to manoeuvre on either side. This said, the Bank of England has stated that any economic damage caused by Brexit will be small in comparison to the pandemic. Nevertheless, while this persists, international investors are unlikely to return to the UK market. So where else can support come from?
The FTSE has traditionally been a high dividend paying market. Investors looking for income have tended to have a higher proportion of UK equity than overseas. However, the latest crisis has seen dividend cuts across many companies: this week, BP and Glencore joined this trend. We may see dividend distributions on the FTSE 100 halved. This will still leave the yield close to 3%, which remains higher than many other developed markets. With ten-year gilts yielding just 0.10% and even 30-year gilts at 0.63%, this may still look attractive. This will make life very difficult for those who live off the income from portfolios. We have urged a total return approach wherever possible.
If you are looking for a more positive outlook, the cut in dividend distributions and share buybacks will help companies survive the pandemic. As a result, some companies may come out of this with stronger balance sheets and be in a better position to grow and expand their operations when the pandemic has passed. This will depend on the speed with which the world recovers from the pandemic, which remains clouded in uncertainty.
Given the sector biases in the market, the reduced income and Brexit, sterling-based equity investors have increasingly looked to invest more internationally, which has produced much better returns in recent times. For the UK to outperform again, we need to see a rotation out of the fashionable tech sector into less fashionable areas such as energy and materials, which are more sensitive to changes in the economic landscape. Furthermore, widespread availability of an effective COVID-19 vaccine could see a sharp economic recovery and a pickup in demand that could favour the UK market. We would also need to see a favourable resolution to the post-Brexit trade talks, which would help the more domestically-oriented stocks, and encourage international investors to return to the market. While neither of these events appears imminent, it is possible the situation will change as we move into the new year.
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