Should you invest in the UK stock market today?

What you’ll learn:

• What happened to UK dividends over the second quarter of 2020?
• Are dividend cuts good for companies?
• Do UK equities present an attractive investment opportunity?

The FTSE All-Share Index has fallen almost 13% over the year to the end of August 2020 (Figure 1). But the FTSE World Index, representing companies around the world, has actually risen in value over the same period. Although, past performance is not a reliable guide to future performance. The UK market has underperformed other stock markets for some years, starting even before the EU Referendum vote. So is now the time to invest more in your own home market?

Many fund managers would say ‘yes’. We, the Manager Selection team at Barclays, are aware of almost half a dozen firms looking to launch new UK equity funds in the next few months, mainly investing in medium and smaller sized companies. But we would be cautious – the rest of the year and beyond is full of potential banana skins for UK funds to slip on.

Dividends – A record quarter, but not for a good reason

The second quarter of 2020 will be remembered by UK equity investors for the size and amount of dividend cuts companies had to make. According to Link Group’s second quarter UK Dividend Monitor, 176 listed companies cancelled their dividend entirely (out of approximately 600 constituents of the FTSE All-Share Index), and 30 companies cut them in the three months to the end of June.

In total, dividends paid by the UK’s largest companies (those that make up the FTSE 100 Index) fell by almost half in the period. The quarter was even tougher for investors in medium sized companies. There, fewer than a quarter of all companies didn’t cut or cancel their dividends. Link’s report suggests it could take until 2026 for UK company dividends to again reach the amount paid in 2019. The FTSE All-Share Index dividend yield (the dividend per share, divided by the price per share) is estimated to be 3.6% by Link in 2020 – still healthy but less so than before the pandemic.

While some companies and sectors chose to not pay dividends during the height of the pandemic, and may well reinstate them in the future, for others the decision was one they had to take to survive a period where they had no revenue to offset their costs. Most UK equity income funds are expecting to cut their payments to fund holders by between 30%-50% this year, based on our conversations with them.

Is this a good thing? Probably, but not for those needing income

While equity income investors will beg to differ, is this a good thing for UK companies? Some fund managers have complained for years that many UK companies prefer to pay a dividend to investors rather than invest in their business – and the dividends they have paid were unsustainably large. The size of cuts across the market suggests that these managers may have a point.

But some businesses are on the front foot. A number have issued more shares, not because they have to, but because they see opportunities. For example, some high street furniture retailers and hotel operators have both raised money from investors, and will spend it on buying more stores and hotels. Other companies may use the crisis to invest elsewhere in their business – perhaps through paying higher wages to staff, improving their supply chains or investing in their technology to meet the ever increasing demand of online sales.

Predictions are hard, especially about the future

There is nothing harder to predict than the future, as someone once said. What impact will the end of the furlough scheme have on the UK economy and unemployment? What will be the outcome of Brexit negotiations with the EU and trade talks with other countries? Will a coronavirus vaccine be found in the near future? What about the US presidential election? Will inflation return?

If any of these questions are answered, it’s possible that certain sectors may recover very quickly. A viable vaccine for coronavirus could see a sharp rally in the performance of the travel and leisure sector, with airlines and restaurant businesses benefiting from improved consumer confidence. A return of inflation could see financial shares perform well, as government bond yields rise and profit margins increase. Exporting sectors – such as the UK’s manufacturing base – could be boosted from the clarity and certainty provided by the UK signing trade deals with Europe and elsewhere.

Investment conclusion – being brave could be foolhardy

After the cuts to dividend payments across the market, one of the remaining reasons for global investors to own the UK market – its attractive dividend yield – is no longer so appealing. However, many fund managers we speak to think these concerns are priced into share prices. In other words, they think the UK stock market is cheap. What the market lacks is a catalyst, a reason for share prices to move higher and sentiment to improve.

Valuations are a widely contended topic with each measure possessing its own pros and cons. It is well documented that, over long time horizons, the price which you pay for an asset plays an important role in future returns – the less you pay for the asset, the greater the potential gain (or smaller potential loss). So, for investors who have the luxury of such a time horizon, UK equities may represent an attractive relative opportunity.

However, cheap valuations (where shares are priced attractively compared to their long-term average) alone aren’t sufficient. Given the UK’s significant exposure to the energy and financial sectors (as well as its relatively small exposure to technology), investors would need to muster the confidence in these sectors performing strongly. For now, our convictions lie elsewhere.

The UK is still a major global market, home to a number of highly respected, multinational businesses. Investors who already have exposure to the UK as part of a diversified portfolio may want to retain that position if it is appropriate to their circumstances. For those without UK exposure, a cheaply priced index fund or an active fund run by an experienced manager may be an appropriate option if they wish to gain exposure to the market. However, it is important to consider currency risk when investing overseas or in UK companies which earn some or all of their income from overseas.

Currency risk can have a positive or negative impact on investment returns. For example, if a UK-listed company generates revenue in euros, the value of those euros in sterling terms will vary depending on the exchange rate. If sterling weakens, each euro will buy more pounds so the company would benefit from higher earnings. However, the opposite is also true. If sterling rises against the euro, each euro will buy less pounds and the company would be worse off. The company may choose to hedge their currency exposure which could help to minimise this risk.

To best navigate the current market uncertainty, we would advocate taking a long-term diversified approach to investing. The Barclays Ready-made Investments are just one example of a range of diversified funds which allow you to select the level of risk you are most comfortable with. These multi-asset funds invest across a range of asset classes and regions, offering a globally diversified one-stop solution for investors. Ready-made Investments are not the only funds that we offer and they won’t be appropriate for everyone.

Smart Investor offers a wide range of funds, and our Barclays Funds List may help you to narrow down the wide range available to invest in. These funds are selected by Barclays investment specialists and, based on our research, they’re the funds that have built solid reputations and established sound investment processes.

We don’t offer personal investment advice so if you’re unsure you should seek that independently.

Funds are designed for the long term so you should only consider them if you can stay invested for at least five years.

All of these investments can fall in value as well rise; you may get back less than you invest.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.