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U.K. Investors Vote Against Uncertainty

Equities popped after Prime Minister Cameron retained power, but valuations may be getting overstuffed, writes Morningstar U.K.'s Emma Wall.

Note: This article is part of Morningstar's May 2015 International Investing Week special report.

The United Kingdom has a new political party in power--and it's not the result many investors were expecting. On May 7, the British people went into polling booths across the nation and, on May 8, a majority Conservative government was in power. Investors in U.K. equities rejoiced.

Putting political policies aside, the most important aspect of the U.K. general election, as far as the stock market is concerned, is that the man who runs the country is the same this month as it was last month--Prime Minister David Cameron. And the market loves nothing more than certainty.

It had been predicted that the general election would result in a coalition government of various political parties. Speaking at a pre-election event, Bill McQuaker, multiasset investor at Henderson, said that the U.K. was in a "worse position than the Fragile Five economies when the taper tantrum hit," referring to the five economies of Turkey, Brazil, India, Indonesia, and South Africa, which saw their currencies plummet in July 2013 after then-Chairman of the Federal Reserve Ben Bernanke announced plans to taper U.S. quantitative easing.

McQuaker said that without a stable U.K. government, he expected sterling's fate to be similar to those countries. As the election result was revealed, "short-term uncertainty had been avoided and growth headwinds caused by electoral uncertainty have abated," McQuaker said.

"Equities have rallied somewhat, and the pound has bounced," he added. "Looking further ahead, the markets seem unlikely to push these moves too much further. The likelihood of a fresh round of austerity probably means less growth and a different policy mix than seemed likely only yesterday. Slower growth may dampen equity-market enthusiasm, while less upwards pressure on interest rates could keep a lid on sterling."

He was not the only one to recognize the positive effect of the election result on the markets.

Renowned U.K. equity-income investor Neil Woodford, who runs Bronze-rated Woodford Equity Income, said the result of the election "looks much better than expected--that isn't a politically inspired statement, but one that is based on the fact that such a decisive result removes the risk of the prolonged period of political uncertainty that we had expected to prevail. That is reflected in the surge in the pound."

The election had threatened to derail what has been a fantastic bull run for the FTSE 100 Index of U.K. large caps. While the S&P 500 had comfortably recovered from the global recession by 2013--breaking through its all-time high in April of that year--U.K. stocks took a little longer to hit that all-important record.

In February of this year, the FTSE broke through its all-time high of 6,930--last seen on the final day of 1999, prior to the bursting of the dot-com bubble. A month later, the index broke through 7,000.

Too Late to Buy? But do these seminal highs mean that it is too late to buy in to U.K. shares? If you had been savvy enough to pick up stocks on the cheap in 2008, your contrarian bet would have paid off. Developed-markets equities in the U.S., U.K., and Europe have benefited from an incredible rally since the lows of the global financial crisis. Now, many asset allocators say that the market looks overvalued, but opportunities are still available to savvy stock-pickers.

The threat of deflation is a redundant one, according to McQuaker--if you strip out energy and food costs, inflation in the U.S. and U.K. is largely running at the 2% target. Employment in both countries has returned to prerecession levels, and wage growth has begun to appear.

These barometers, alongside healthy GDP growth, mean that the Bank of England will soon be unable to justify current monetary policy, and the flood of cash that has so supported equity and bond prices in the last five years will cease. This means that before too long, quantitative easing will cease and interest rates will rise.

Clive Beagles, who runs Silver-rated JOHCM UK Equity Income, says that investors have been working in an environment where interest rates haven't gone up for five years, which has had a big impact on how different stocks and sectors have been valued in the equity market.

"For us, the key element actually is that certain stocks and sectors will do well as interest rates rise, and actually some might do quite badly--and some of those may be sectors that people previously have thought about as being very defensive," he said at the recent Morningstar Investment Conference in London. "Those actually may be some of the stocks that fare worst in an environment in which interest rates rise."

These bond proxies have seemed attractive to investors in the past 18 months, as they pay out a steady income stream, which cash and bonds no longer provide in any measure. But they are expensive and will suffer in any market correction.

Instead, Beagles suggests unloved sectors such as commodity stocks, banks, and even food retailers--all of which were among the worst-performing companies in 2014. "If you look at the areas that we currently find attractive, it's things like financials, it's areas like commodities, or it's small caps--all of which are less fashionable," he said.

"The more fashionable areas of the market right now would be biotech or technology or consumer staples. There might be some good-quality companies in those sectors, but they are valued on quite high multiples, and it's hard for us to see how you make money in those sorts of names. You're more likely to make better returns from lower valuations as your starting point."

Woodford agrees, saying that he is pessimistic about the outlook for the markets as a whole--and now more than ever, investors should be looking for good active managers to separate the wheat from the chaff.

"We are due a major market correction. But I said that in 1999, and the stock market rallied for a further 18 months. When I think about the investment environment, I would say it is as challenging as the economic environment. The risks are greater than they were three or four years ago. It is a very difficult situation for fund managers," he warned.

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