UK Equity: 2019 OutlookDec 7, 2018

Key Points

The final quarter of 2018 has seen the confluence of an unusually high number of negative forces creating a perfect storm for equity investors. The determination of the Federal Reserve to ‘normalise’ US short term interest rates, the ongoing trade spats, the Italian budget dispute and last, but certainly not least, the ongoing Brexit deal debates have all played their part in undermining investor confidence.


Colin Morton

Colin Morton
Portfolio Manager
Franklin UK Equity Team

What IS THE UK Equity Market Anticipating in 2019?

The final quarter of 2018 has seen the confluence of an unusually high number of negative forces creating a perfect storm for equity investors. The determination of the Federal Reserve to ‘normalise’ US short term interest rates, the ongoing trade spats, the Italian budget dispute and last, but certainly not least, the ongoing Brexit deal debates have all played their part in undermining investor confidence.

The matrix of potential outcomes on Brexit alone are mind boggling but add in the other factors and making any conviction call on the short-term outlook for the UK equity market becomes all but impossible.

Despite the media obsession with Brexit, an escalation of the trade dispute between the US and China represents the major risk to global equities and ultimately the UK equity market. Even in the more unlikely Brexit scenarios there will be areas of the UK market that hold attractions but the route to a global recession lies via trade tariffs and a Fed induced policy mistake.

Given the multitude of current uncertainties, it appears irresponsible to position portfolios at any extreme. A portfolio of domestic cyclical stocks could deliver outstanding returns under the most benign scenarios but may also leave a fund manager trapped in illiquid assets for multiple years under an equally plausible negative turn of events.

So, what does the responsible fund manager do under these circumstances? We believe, first and foremost must be an emphasis on quality. You need to be invested in companies that offer a clearly visible path to value creation under as many different scenarios as possible. Ultimately, this late in to an already extended economic cycle, balance sheets demand greater attention: a strongly capitalised business has far greater chance of emerging from a period of economic dislocation with its market positioning enhanced.

The investment process across our fund range is hopefully well understood and we intend to remain faithful to the principles we have consistently applied over many years.

trade and the Federal Reserve

The year is ending as it began with a period of market volatility that has its roots in the US. Early in the year it was the sharp rise in US bond yields, and its obvious implications for the cost of capital, unnerving investors as the global economy appeared on track for a synchronised upturn. Now attention is focused on the potential negative impact from trade tariffs and an inverted yield curve as the Federal Reserve appears determined to press on with normalising policy.

The danger is the Fed carries on oblivious to a tariff inspired slowdown in the global economy and realises too late that it is looking in the rear-view mirror.

We remain hopeful however that the policymakers will shortly signal a more moderate pace of rate increases in 2019 but are less confident that the tariff issues will conveniently melt away. We tend to agree with those that believe the US agenda has as much to do with limiting China’s future geo-political influence as it has to do with trade deficits.

From a stock market perspective, with a lot of negative news already priced in we could realistically hope that the absence of further negatives may at least lead to some stabilisation in equity prices.

The US economy will almost certainly slow in 2019 as the impact of this year’s tax stimulus fades; it is really a question of degree. The tax cut package and attendant rise in the fiscal deficit has certainly raised the stakes for the US.

Brexit and the UK

The parliamentary defeats over the EU deal do however make it less likely that there is a disorderly hard Brexit as there is now a demonstrable path to prevent this in the hands of MPs.

What happens next remains uncertain with a wide range of potential scenarios. The key risk is still that the ruling Conservative Government tears itself apart and a General Election is called resulting in a Corbyn government. We believe this could be a far more damaging outcome for the UK equity market than any of the potential changes to the relationship with the EU.

One of the few things we can be confident of is that the whole debacle has further to run and is expected to continue to cloud sentiment towards UK equities at least through Q1 of 2019.

It is widely understood that the weakness of sterling and the lowly valuations on domestic facing stocks reflects the extreme investor positioning whilst the uncertainty persists. This creates a potential opportunity if the worst-case scenarios can be avoided, and we are very much alert to this.

UK Equity Valuation

The UK Equity market is optically cheap on a forward price earnings multiple of less than 12x for 2019 with a dividend yield close to 5%.

The overall market has moved from a premium to its long-term average rating at the time of the referendum to a discount today.

The discount reflects both the risk premium attached to UK equities at a time of elevated uncertainty but also the lack of confidence in forward earnings estimates.

The consensus for market earnings growth in 2019 is of the order of 7% but the range of potential outcomes is unusually wide and within individual sectors even more so.

The decline in the equity market is clearly discounting a weaker outcome than envisaged in these consensus numbers and clearly if the UK economy proves more resilient than feared there is scope for share prices, particularly of domestic cyclicals, to rebound strongly.

IMPORTANT INFORMATION

Source: Franklin Templeton Investments as at 7 December 2018. This document is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or invitation to apply for shares of any of the Franklin Templeton Investments fund ranges. Nothing in this document should be construed as investment advice. Opinions expressed are the authors at the publication date and are subject to change. For more information about any Franklin Templeton Investments fund, please contact: Franklin Templeton Investments, Telephone: 0800 313 4049, Email: ftisalessupport@franklintempleton.co.uk or write to us at the address below. Issued by Franklin Templeton Investment Management Limited, Cannon Place, 78 Cannon Street, London EC4N 6HL. Authorised and regulated by the Financial Conduct Authority.

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