By Michael Stanes, Investment Director at Heartwood Investment Management
It was widely expected that 2015 was the year that election uncertainty in the UK would hold back the UK equity market and stall corporate investment.
So far this has yet to transpire, despite recent polls suggesting the two main parties remain locked in a state of non-majority limbo. Faced with the prospect of a Labour-SNP, Conservative-Liberal Democrat or even a Conservative-UKIP coalition, one might have expected subdued-at-best returns from UK risk assets in 2015. Yet as we sit here today, the UK market (MSCI UK) has so far returned a healthy 5.7% (all data in sterling terms), outperforming both the US (MSCI North America up 4.2%) and the broad World index (MSCI World up 5.2%) in the year-to-date. So what has happened to drive these stronger than predicted returns?
Firstly, we have started to see positive signs of growing momentum in the UK economy. Last week, it was announced that earnings grew at a better than expected 2.1% in December, which is the highest monthly figure since June 2013 and the seventh monthly increase in a row. There were further signs of strength in the labour market with the official unemployment estimate for December coming in at 5.7%, down from 5.8% the previous month. Ahead of the March budget, we also had the announcement that the UK had posted its biggest budget surplus in seven years in January.
As well as uncertainty surrounding the election, the composition of the UK market had been expected to hinder returns going into 2015. Energy and Materials make up approximately 23% of the MSCI UK index (versus 13% of the MSCI World index), and with severe volatility within the commodity complex in the second half of 2014 (Brent Crude fell over 50% in six months), it was expected that weakness in these sectors would act as a drag on the broader market. We did indeed see some weakness in January, however since then commodity prices have rallied somewhat (Brent Crude has gone from $50/barrel back to $60/barrel) and this has been reflected in the performance of these two key sectors. Energy has returned 6.9% this month.
Finally, after a subdued 2014 in terms of equity returns (MSCI UK gained just 0.5% in 2014), valuations had started to look more interesting coming into this year, particularly relative to the US, where the market had returned almost 20% in sterling terms. At present, the MSCI UK index is trading at 14.5x earnings, while the US market is at 18.7x. Although valuations are rarely a good indicator of short term market movements, they may well have been a factor in explaining why the UK has performed well relative to the US so far in 2015.
In terms of our positioning, we have for some time maintained a small underweight in the UK partly based on the factors discussed above (political uncertainty and index composition), but also influenced by what we see as its long term structural weaknesses, such as a growing current account deficit.
Looking forward, we may look to reinvest back into UK assets should they (and the currency) weaken as we head to the election wire. The election result remains too close to call at this point, although the odds currently favour a second term for the Conservative/Liberal Democrats coalition. David Cameron has been hanging his hat on the economy and wage growth in recent speeches – it may turn out to be an extremely well timed move.