Schroders: 2013: A year in the UK



Over a decade ago I warned that equities were likely to go sideways for 10-15 years. Not because I anticipated all the headwinds to growth we now face, but because from a starting price-to-earnings (P/E) ratio above 20x, the stockmarket was always going to struggle..….


 Richard Buxton, Head of UK Equities, looks ahead into 2013  


For professional investors and advisers only. This document is not suitable for retail clients.

Moreover, the pattern of long-term returns from UK equities is made up of extended periods of strong gains and multi-year phases of going nowhere

By 1999 we had enjoyed a near 20-year period of double-digit per annum returns. No wonder equity funds were best-selling and pension funds allocated over 80% to equities. There was no talk then of ‘the death of equity’ or ‘the lost decade’. Fast forward to 2012 and the prevailing mood is gloomy. Outflows from equity funds are unrelenting and money continues to pour into bonds. For 12 years, equity investment has delivered lots of volatility and precious little return, which has led a scarred generation of investors to search for ‘safe havens’.

A difficult backdrop

The economic outlook is tough. Bank deleveraging in the UK and Europe is ongoing. Governments and individuals continue to retrench, ensuring that economic activity islow. China has yet to avert fears of a ‘hard landing’ or show whether it can managethe transition to growth less dependant on infrastructure investment. Meanwhile, thenever-ending attempts in Europe to reconcile austerity and fiscal rectitude grind on. Investors mistrust politicians and politicians mistrust markets – both have summit fatigue.

But this is exactly why the stockmarket now sells on a P/E of just 11x. Everyone knowsand focuses on the bad news – and it’s why equities are good value in absolute and in relative terms. Companies have strong balance sheets, good cashflows and risingdividends with many companies’ shares yielding more than their corporate debt.

The ‘lost decade’ – the ‘new normal’

There is lots of talk of the ’lost decade’, the ‘new normal’ where banks and governments are going to continue to delever for some years to come. Back in 1999 investors could see no clouds; the outlook now is unremittingly gloomy.

Importantly, in 2012 we struggled to reconcile official GDP data, which has had the economy stuck in recession for much of the past year, with what companies tell us. Companies are telling us that “it is not getting much better but it is not getting anyworse”. Inflation is coming down, albeit slowly and erratically, which should supportsome real income growth over time.

Even though the public sector continues to shed staff, the private sector is creating sufficient jobs that net employment growth is positive.

Equally, even though it is very difficult to get credit from banks, net new business formation (new businesses formed minus the businesses that are going bankrupt) is running at double-digit year-over-year rates of growth. It’s really important for the UK economy that new businesses are being created because most people are employedby small businesses, not large ones.

Three big concerns…

Investors have three immediate concerns. Can the US avert falling over the ‘fiscal cliff’? Will China achieve a ‘soft landing’? Can Europe make meaningful progress in addressing its sovereign & banking crisis? Over the course of 2013 I believe fears will reduce on all three fronts. The US is likely to agree a fiscal policy which turns the ‘cliff’ into a gentle slope. Given that US banks are creating credit again and that an improving housing market is underpinning consumer confidence, a positive agreement will reassure US corporates. Having held back on spending ahead of the Presidential election and the ‘fiscal cliff’ negotiations, a satisfactory outcome should see a resurgence in investment and orders. Stronger activity in the US could lead global growth in 2013.

Equally, now the policy vacuum in China prior to the leadership transition is over, better economic data and modest policy stimulus should ease fears of a ‘hard landing’. Against a background of improving activity in the US and China, even Europe may fail to dominate investor sentiment. Much progress has been made this year in the multi-year evolution towards fiscal union and the appropriate mix of austerity, reforms and fiscal transfers. Expect further progress in 2013.

…and one overriding worry

Investors’ overriding worry is that the scale of debt in the West condemns us to weak growth for the foreseeable future. If the three immediate concerns fade, however, even this cornerstone of the bear case may be challenged. Some modest acceleration in growth is key to deficit and debt reduction. Undoubtedly, risk appetite will continue toebb and flow with the macroeconomic data, but an improvement on the deteriorating trend of recent months would help reinforce a potentially virtuous circle of improved corporate confidence and investment.

Ironically, one of the most positive signals next year could be the Federal Reserve beginning to walk away from QE or signal that interest rates may rise sooner than as currently flagged in 2015. Now that US banks are creating credit once more, a signalthat monetary policy is moving out of emergency mode back towards more normal settings may reinforce CEO confidence rather than undermine it. One to watch in 2013.

A trend that’s really an escalator

Meanwhile, let’s revisit the current bear phase in equities in its longer term context. In the long run – and we have gone back well over 100 years – the annualised return for UK equities is 4.8% per year after taking into account the effects of inflation. Not bad you might think, but those returns are enormously cyclical; there are extended periods of fabulous returns, and extended periods where there are no returns at all. The long-run trend is made up of a series of escalator-type movements.

My supposition back in 2002 was that following a fantastic bull run throughout the 1980s and 1990s, we were due one of those periods where the market goes up and down, but doesn’t make much progress. Roll the clock forward 10 years, and sadly I was right. While there has been a total return from the market over the last 10 years, it has primarily been made up of dividends. In pure index terms, UK equities are still below their peak in 2000 – the market has gone sideways.

Valuations are the key to future returns

Starting valuations – not the economic outlook – are the key to future returns.The chart below illustrates the correlation between your starting UK equity valuationsand subsequent 10-year market returns, going back to 1900.


From a 22x multiple 10 years ago, you would have struggled to make money from investing in equities even if the macroeconomic environment had been much better.If history is any guide, then from today’s valuations – a P/E multiple of 11x – the next10 years should provide positive real returns for investors, possibly double-digit per annum, despite the economic headwinds we face. I am much more optimistic aboutthe returns from UK equities over the coming decade than I was 10 years ago.

No-one rings a bell to start a bull market…

We know there are lots of negatives in the macroeconomic environment and lotsof headwinds to growth, but it is widely known and is reflected in prices. Economic growth and equity markets do not correlate. Growth could be subdued, but a lessening of extreme fears could see equities rerated nevertheless. The fund flow statistics and negative sentiment towards equities suggest that the ‘pain trade’ for most investors is for the equity market to surprise commentators on the upside over the coming years because people don’t have enough equity exposure. 2012 saw frequent referencesto the ‘death of equity’ as an asset class – surely a stimulus to the contrarian instinct.I believe we can say we have already passed the low point for UK equities – below3500 on the FTSE 100 index twice in the last 12 years – and are in the foothills ofa new bull market


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For professional investors and advisers only. This document is not suitable for retail clients.

This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
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Source: ETFWorld – Schroders

rated “BB”. 13% of the basket is rated “B” and this is one issuer, Venezuela. So the country
with the biggest weight in the index is also the country with the lowest rating. While
Venezuela is clearly a high risk country with 13% weight in the index, the remaining countries
are clearly more solid (for more details on the “MSCI USA TRN” ETF see ETF: Ideas and
Flows, 25 November 2009).
“db x-trackers Currency valuation” ETF 20% weight
In currency markets the majority of the participants are “liquidity seekers”. “Profit seekers”
are a minority in currency markets and can generate returns on the expense of the “liquidity
seekers”. Profit-seekers can generate returns by buying “under-valued” currencies and
shorting “over-valued” currencies. A widely used measure to determine “under-valued” and
“over-valued” valuation for currencies is the concept of “Purchasing Power Parity” where
“fair” exchange rates are calculated by comparing the prices of a basket of goods in different
countries. The ETF “db x-trackers Currency valuation” buys each quarter the three currencies
with the “lowest” valuation out of the universe of the G10 currencies and sells the three
currencies with the “highest” valuation using the PPP concept. In addition, the correlation to
equities and bonds is very low and therefore the currency valuation index helps to diversify
our ETF portfolio. The index is currently long in the US Dollar, New Zealand Dollar, and the
British Pound whereas the index is short in the Swiss Franc, Swedish Krona and the
Norwegian Krona. Risks to the investment include that currencies movements become less
rational again. Especially increased uncertainty about the economic development could
trigger a flight back into expensive currencies like the Swiss Franc (for more details on the
“db x-trackers Currency valuation” ETF see ETF: Ideas and Flows,12 June 2009).
Trading portfolio
We have kept the portfolio unchanged this time. Earlier we bought the “Emerging Markets
Liquid Eurobond Euro Index” ETF with 10% weight and sold the “db x-trackers DJ Stoxx
Global Dividend 100 ETF”. The portfolio targets absolute return and has the EONIA index as

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