Investment Trusts

Outlook 2019: Schroder Income Growth Fund plc

Sue Noffke, Fund Manager, Schroder Income Growth Fund plc takes some comfort in the fundamentals supporting UK equity valuations against a market backdrop clouded by uncertainty over Brexit.

16/01/2019

More often than not, global developments set the tone for UK equities and the market gyrations seen in the fourth quarter of 2018 are a timely reminder of this. The major domestic issue of Brexit has taken a back seat. Instead, the driving forces are international; including US-China trade tensions, European political uncertainty, and the end of quantitative easing/rising interest rates.

Global trends like these will continue to be crucial. But so will Brexit, with many potential pitfalls in the run up to and beyond the UK’s scheduled departure from the EU on 29 March 2019. The UK government has negotiated a “withdrawal agreement” with the EU. However, if parliament rejects the deal, and a delayed Brexit is not agreed the UK will be leaving the EU on 29 March 2019 without a deal, with the risk of a UK recession.

As a consequence of Brexit, UK domestic-focused companies have significantly underperformed those companies which generate their earnings overseas in 2018. Sterling weakness has been a major driver of this as overseas earnings become more valuable when brought back to the UK when the pound is weak. However, the underperformance has also been in large part due to UK domestic companies suffering a “de-rating” (see below for explanation) amid fears the UK economy would grow at a lower rate outside the EU.

The dividend yield of the UK stock market is at an equivalent level to that seen before and after the peak of the global financial crisis (GFC) in 2008/09. However, I don't believe we are likely to see a recession in the order of magnitude experienced following the GFC. If we do see a recession, I would expect it to be local to the UK (possibly the result of a “no deal” Brexit), rather than global, albeit world economic growth looks set to moderate in 2019. This gives me a degree of comfort that this elevated yield is sustainable (rather than a signal of impending distress) as the large majority of UK stock market dividends derive from overseas.

Past performance is not a guide to future performance

The extreme level of pessimism towards the UK stock market also becomes apparent when you study the dividend yield gap between UK and global equities. The UK stock market has historically offered a higher yield than other regions, however the premium is now at its most elevated in almost 20 years, at a level not seen since the 1999/00 dotcom bubble.

As 2018 comes to a close many market commentators are rightly drawing parallels to previous occasions when the market cycle and “business cycle” (the period of time in which an economy moves from a state of expansion to one of contraction, before expanding again) were in more advanced stages. The pick-up in volatility certainty reflects a growing nervousness around the outlook.

Again, however, I take some comfort in the fundamentals. The short-term outlook for underlying UK dividend growth (excluding both special dividends and exchange rate movements) has improved, due to the strengthened pay-out ratios resulting from rising commodity and oil producer profits. Meanwhile, that other big driver of UK dividends, the banking sector, is finally returning to form 10 years after the GFC.

Should a “no deal” Brexit be averted, there would likely be an upwards movement in sterling and a re-rating of the market. This would be particularly beneficial to those UK domestic companies that have suffered a severe de-rating over the last two and a half years (The rating of a sector or an area of a stock market is a measure of how highly, or lowly, investors value it. It can be expressed by a variety of valuation metrics, such as the price-to-earnings (P/E) ratio. The P/E of a sector/area is its current level divided by its expected aggregate future earnings – when the P/E falls, the sector/area is said to have suffered a de-rating).

UK-focused banks, property companies, house builders, consumer discretionary areas (general retailers and leisure companies), food retailers, media agencies and utilities are all trading on depressed ratings. This is clearly seen in a range of valuation metrics, including price-to-earnings (P/E) ratios, which for some of these sectors are now in single digits.

Discrete yearly performance (%)

Discrete yearly performance (%)

 

Q3/2017 - Q3/2018

Q3/2016 - Q3/2017

Q3/2015 - Q3/2016

Q3/2014 - Q3/2015

Q3/2013 - Q3/2014

Share price

7.3

14.8

4.7

2.5

9.3

Net Asset Value

4.9

13.0

13.3

2.1

10.7

FTSE All Share Total Return

5.9

11.9

16.8

-2.3

6.1

 

Past performance is not a guide to future performance and may not be repeated.

Some performance differences between the fund and the reference index may arise because the fund performance is calculated at a different valuation point from the reference index.

Source: Schroders, with net income reinvested, net of the ongoing charges and portfolio costs and, where applicable, performance fees, in GBP as at 30 September 2018.

The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.

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What are the risks?

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

Companies that invest in a smaller number of stocks carry more risk than funds spread across a larger number of companies.

The Company will invest solely in the companies of one country or region. This can carry more risk than investments spread over a number of countries or regions.

As a result of the fees and finance costs being charged partially to capital, the distributable income of the Company may be higher, but the capital value of the Company may be eroded.

The Company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

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Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.  Exchange rate changes may cause the value of any overseas investments to rise or fall.

Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell.

The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.

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