A combination of lower inflation, growing expectation that central banks will cut interest rates and a gradual upswing in growth has led to a performance reversal of the previously strong defensive sectors, says JOHCM UK Equity Income Fund.
Conversely, cyclical sectors, the financial and commodity sectors, are now outperforming. In addition, an increase in M&A, along with a strong results season, have also contributed to this mix shift, says JOHCM.
According to JOHCM UK Equity Income Fund fund managers Clive Beagles and James Lowen, the seven leading defensive stocks – Unilever, AstraZeneca, RELX, Glaxo, BATS, London Stock Exchange and Diageo – which make up 21% of the FTSE All Share, are seeing “fundamental issues” come to light. These include excess leverage, prices pushed too far and companies losing market share.
The duo also said they were forecasting “flattish” dividend growth for 2024 versus 2023. This was driven by a number of factors, including the prioritisation of share buybacks, delayed UK domestic dividend growth and the mining sector dividend impact, with the recent acquisition of Teck businesses by Glencore temporarily reducing its flow of dividends. In addition, JOHCM said it also expects modest sterling appreciation in 2024 which would dilute the value of dividends received in foreign currencies.
Looking ahead, Beagles and Lowen said they expect inflation to continue to fall below 2% in the next three months, prompting the Bank of England to likely reduce rates and accelerate economic activity.
“In many respects, rate cuts in the UK will be as much about boosting both business and consumer confidence as it is about reducing the cost of money,” the pair said.
With UK savings ratios elevated relative to pre-pandemic levels, only a modest degree of monetary easing will likely be required to boost spending and activity materially, according to JOHCM. The impact this will have on international and domestic investors’ view of the economy and the UK stock market will be just as important.
“With UK inflation no longer an outlier in an international context and an economy that has the capacity to rebound reasonably sharply, the very low valuations on offer in the UK market will begin to attract fresh interest,” the fund managers said.
They cited banks as an example of the current state of play of the UK equity market. Whilst they have enjoyed a strong move higher so far this year, they have the potential to still broadly double before they reach a valuation on par with their international peer group or in keeping with their likely Return on Equity.
