U.K. Economic Recovery Sparks Asset Allocation Shift
Managers expect financial stocks and property to benefit the most, but lofty equity valuations could limit gains.
The U.K. economic recovery appears to be gaining strength after years of meager growth. The International Monetary Fund has upgraded its forecast for U.K. output growth in 2014 to 2.4 percent from 1.8 percent in October. Even this healthy figure, close to the country’s long-run average, pales beside the average forecast of 2.7 percent among independent economists surveyed by the U.K.’s Treasury.
Key to the recovery is the continuing fall in U.K. unemployment, which is supporting consumer spending. At 7.1 percent, it is at its lowest point since 2009. A housing boom, fueled by low interest rates, is also injecting life into the economy, boosting construction output and ramping up mortgage approvals to a five-year high.
Another important positive factor is the upturn in the euro zone, which takes about half of the U.K.’s exports. “The euro zone is now more of an opportunity than a risk,” says Steve Davies, a U.K. equities portfolio manager of London-based Jupiter Asset Management, which has £29.9 billion ($48.9 billion) in assets under management. Economic activity in the euro zone grew at its fastest rate in two and a half years in January, according to the Markit flash euro zone composite purchasing managers’ index.
Many institutional investors are responding by reducing their allocations to U.K. government bonds — known as gilts. Bond prices are expected to fall as the Bank of England approaches the point at which it feels the need to raise its benchmark interest rate above the current level of 0.5 percent. In January Citigroup brought forward its prediction of the first rate rise from the first quarter of next year to the final quarter of this year, though many other economists do not expect a rise until 2015. The yield on ten-year gilts was 2.71 percent at the beginning of February, up from 2.36 percent at the beginning of August.
The Bank of England had set a 7 percent unemployment threshold for considering an interest rate hike, but central bank Governor Mark Carney said in late January that the threshold was not a trigger and that investors should make “no assumption of an immediate, automatic change” in rates.
As money pours out of gilts, the question becomes, What is the U.K.’s asset of choice? Davies sees opportunities in U.K. bank stocks, including Lloyds Banking Group, the U.K.’s biggest mortgage lender and checking account provider. Another candidate is Barclays, “still trading at rock bottom multiples,” including a price-to-book value of 0.73. He says there are also initial public offering possibilities this year, including potential flotations of TSB, a bank spun out of Lloyds this past year, and of HSBC Holdings’ U.K. arm. Davies thinks that rising employment will reduce the banks’ loan impairments and foster credit growth. As for how to tap into the euro zone recovery, he suggests investing in International Consolidated Airlines Group, the British-Spanish holding company for British Airways and Iberia.
The stock market is no longer cheap, though, as increasing numbers of investors react to the prospect of U.K. growth by buying risk assets. Shaniel Ramjee, investment manager of the global multiasset team at London-based Baring Asset Management, which manages $60 billion, says the forward price-earnings ratio for the next 12 months for the FTSE all-share index is about 13. This is a little below its long-run average, but not greatly so. He expects actual price-earnings for 2014 of only 14 or 15, suggesting that most of the value is already in the price. In particular, the conventional investment strategy for recovering economies, investing heavily in small- and midcaps, looks problematic. “Small- and midcaps performed well last year relative to the FTSE 100,” says Ramjee. “Going forward, we don’t think the performance will be as great.”
The FTSE all-share index rose by 16.7 percent during 2013; the FTSE 100 rose only 10 percent in the same period. The difference reflects the share price increases of small- and midcaps, which are in the former index but not the latter.
Property is no longer cheap, either. Prime commercial property — real estate in highly sought-after areas, with long tenancies and low vacancies — has been rising since 2010. “Prime property now looks like fair value or even slightly over fair value in some parts,” says David Skinner, chief investment officer for real estate at London–based Aviva Investors. Aviva Investors has £22.5 billion of property assets under management, of which four fifths is in the U.K.
Values in the so-called secondary market — property in less-sought-after locations or with shorter tenancies — have only been going up since mid-2013, the point at which faith in the U.K. economic recovery started to grow. Average yields for secondary office property outside the wealthy southeast of England, including London, are an attractive 11.1 percent, according to the latest figures from Aviva, down modestly from the 12 percent level at the end of 2012 but more than double the 5.5 percent in 2007, before the nationwide property crash. Secondary yields stand a ripe 4.7 percentage points higher than prime yields, compared with a spread of only 0.7 percentage points in 2007. Skinner sees good value in the so-called M4 corridor, the strip of land adjacent to the M4 freeway running from London to South Wales that has in recent years become a high-tech hub.
Peter Martin, head of manager research at JLT Employee Benefits, the London-based pension consultancy, advocates secondary assets but with an eye on the possibility that the recovery might accelerate inflation. He is keen, therefore, on public housing, for which rents are generally linked to inflation. He also likes inflation-linked leases of supermarket store sites, including those of Tesco, the supermarket chain.
Investors worry, however, that growth itself could be based on shaky fundamentals.
One of the key weaknesses of the U.K. economy is its low wage growth. Average annual employee earnings growth in the fourth quarter of 2013 was only 0.9 percent — far below the year-on-year consumer price inflation rate of 2.2 percent in October, 2.1 percent in November and 2 percent in December. Given this, many investors remain wary of retail stocks. They argue that rising household consumption, which has bolstered the economic rebound, is not sustainable. Much of it has been funded by a fall in the household savings rate, to 5.4 percent in the third quarter of 2013 from 7.8 percent just a year earlier.
Neil Williams, chief economist at London-based Hermes Fund Managers, thinks the economy is being sustained by a series of bubbles — including one in the housing market — and that these bubbles are being kept aloft only by low rates. “At some stage bubbles will burst,” he says, “and if they all burst together, then we’re back to 2008,” when almost all asset prices fell heavily.