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After Sprinting Ahead, U.K. Stocks Face Growing Headwinds

Political risk ahead of the May election and lofty valuations limit the upside, but a strong economy should underpin the market, investors say.

Like a marathon runner who keeps a steady pace for miles and miles before making a hell-for-leather dash in the final few hundred yards, the U.K. stock market has been going the distance — and showing a pretty strong finishing kick.

After spending much of the past two years in a narrow trading range, the FTSE 100 index of large-cap U.K. stocks has accelerated since December, finally leaping above its 1999 record high and breaking through the 7,000 mark for the first time. The FTSE 250, which provides more direct exposure to the economy because of its large number of domestically focused midcaps, has put in a similarly impressive performance in recent months. Will the runner keep sprinting?

Bullish investors say it will, because of the strength of the U.K. economy. The Office for Budget Responsibility, a governmental advisory body, forecasts that the economy will grow at a 2.5 percent pace this year, down slightly from 2.8 percent in 2014 but still one of the fastest growth rates among developed countries. Healthy consumer demand is driving the economy, thanks to stronger wage growth and a fall in inflation, to precisely zero in February.

“In the last two weeks, I’ve talked to homebuilders, retailers, car dealers, advertising companies and travel agents,” says Steve Davies, co-manager of the Jupiter U.K. Growth Fund at £32 billion ($48 billion) Jupiter Fund Management in London. “At the moment they’re all uniformly positive about the U.K.” He echoes their optimism by citing the latest “Income Tracker” published by U.K. supermarket chain Asda Stores. This shows a 9.3 percent year-over-year rise in January in what the retail chain calls family spending power — that is, discretionary spending — thanks to falling prices for gasoline, home energy and food and drink.

Confidence among consumers is so high that many are splashing out on kitchen refurbishments — a big-ticket consumer discretionary item that until recently had been held back by wariness over the economy. The Jupiter U.K. Growth Fund has a holding in Howden Joinery Group, a kitchen company that posted a sales increase of 10.6 percent in 2014. The fund has also invested in banks such as Barclays and Royal Bank of Scotland, which are cheaply valued on a price-to-book-value basis and stand poised to gain from broad-based economic recovery as well as their own internal reforms.

These promising economic signs are not necessarily enough, in themselves, to stimulate the stock market as a whole, however. “The macro environment is quite strong, but I don’t see any reason to be constructive on U.K. equities on a relative basis,” says Christoph Riniker, head of strategy research at private bank Julius Baer Group in Zurich. “We have held an underweight stance on U.K. equities since mid-June 2013 and currently see no reason to change our call.”

One of Riniker’s biggest reasons for caution is the general election, to be held May 7. The polls point to a high risk of a hung Parliament, in which no single party wins an overall majority. There is a strong possibility that the largest party will not even be able to form a coalition that can command an overall majority because of the growing popularity of the Scottish National Party, which is unenthusiastic about striking an alliance with either the left-wing Labour or right-wing Conservative parties that look set to win the lion’s share of seats. “The election is rather more a lose-lose than a win-win situation,” says Riniker. The resulting political instability could, he adds, hit the U.K. economy — and the stock market — by deterring businesses from investing in the country.

Jeremy Whitley, head of pan-European equities at £323 billion Aberdeen Asset Management in Edinburgh, makes a similar point: “The two-party system seemed to work quite well. With a lot more characters, it could be like wading through mud to get to a sensible policy.” Whitley warns that if people are worried about U.K. governmental paralysis, investors will demand a risk premium for holding U.K. shares.

Rory Bateman, head of U.K. and European equities at £300 billion Schroders in London, believes political uncertainty could keep the market on edge for a few months, with some downside risk. Should greater clarity emerge, he sees the FTSE 100 climbing above the 7,000 threshold.

Upside potential may be more limited going forward, investors say. Whitley says that because of dividends, total return on the FTSE 100 has been “quite good” since the depths of the 2008–’09 financial crisis, at about 15 percent a year on average. From now on, though, “it would be difficult to make the case that we will have total returns per annum of 15 percent over the next five years.” According to Whitley, valuations have risen to quite stretched levels. The FTSE 100 is trading at about 16 times projected earnings for 2015, compared with a historical average of 14. He also notes that stocks in the highly internationally focused FTSE 100 will have to cope with slower emerging-markets growth than before, including the slowdown in China.

In other words, we may not see the marathoner sprinting again for some time.

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