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How flow can you go?

by Alex Harvey, CFA

After a bumper few months for equity markets, a recent report (1) from Calastone, the global funds network, showed June was one of the worst months on record for outflows from UK equity funds.  That follows positive UK market performance for each of April, May and June.  The selling was broad based with even passive funds showing a rare negative flow print, so why the rush for the door and are investors cashing in their UK equity chips too early?

When you look at what the UK market has been hit with in recent months, and what the rest of year holds (think Brexit), it is perhaps not surprising that investors want to take some profits off the table after the second quarter rebound.  The first quarter collapse in bond yields and commodity prices did little for an index heavy on financial and energy names.  It was the perfect storm descending on an already choppy sea.  As oil prices dived and the global economy ground to a halt, UK equity prices sank as earnings got heavily discounted.  Then when the market added nearly 10% in Q2 – and 17% in the case of small caps – the loss aversion bias kicks in as investors lock in the quarter’s gains, despite remaining down for the year to date.  The pain of giving up those gains outweighs the prospect of further upside, leading investors to sell early.  

Dividend cuts compound the problem for UK equities in a regional market previously well liked for its income.  We may finish the year seeing dividend payouts cut by a third or more as companies look to retain more cash on the balance sheet and build a buffer for the quarters ahead; the forward-looking dividend yield has fallen by almost a percentage point compared to a year ago.  We have seen a lot of share issuance recently as companies have tapped markets, both to fund ongoing business and in some cases no doubt to fund future acquisitions, so it’s rational to retain more cash than bear the cost of raising it through equity issuance.  Some will do both. 

UK GDP contracted by 10.4% in the three months to April and fell by 20.4% month on month from March to April, a record drop since the monthly data began in 1998.  Industrial production, construction and retail are all notable areas that suffered.  On the political front, the UK is now stepping up the latest round of negotiations with the EU in order to strike a deal ahead of the end 2020 deadline.  With most of Europe about to head out of the proverbial home office for August on their summer vacations, we shouldn’t expect much headway on this in the coming weeks. 

Despite much seemingly negative newsflow we should remember that the UK remains a cheap market today, at its widest discount versus the US since before the 2016 referendum when forward price earnings were almost the same across the two markets.  Since then sentiment has been firmly against the UK and positioning remains heavily underweight.  This leaves the UK as one of the cheapest of the major developed markets today. Even with the lower dividend payouts, UK equities yield a multiple of corporate bonds, and many times gilts.  With around two thirds of revenues coming from overseas, UK equities are a cheap way to access a more globally derived equity earnings stream.

(1) Calastone - Fund Flow Index – July 2020

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