Tuesday, March 11th, 2014

Day in the Sun

Over the last twelve months, Harlyn’s international clients have got used to the sight of UK equities close to the top of our asset allocation ranking. This is not a case of favouritism or home bias. The UK fully justifies its position in terms of risk-adjusted returns, but the scale of the exposure is worth understanding. UK equities currently account for 25% of our US portfolio compared with an average since inception (1996) of 17%. Part of the reason is the current low exposure to fixed income, but the story is the same when we look at equity on its own (29% of pure equity vs an average of 21%). The reason is the strength of sterling, which turns good local currency returns into something really quite attractive in dollars or euros.

A good investor always looks for the catch, and we believe there is a problem starting to emerge. What’s good for overseas investors is not necessarily good for UK investors and one particular variable to which they are very attached – their dividend. Dividends matter to UK investors in a way which other countries sometimes find difficult to understand. A strong pound creates a real problem for dividend growth, and whenever dividend growth comes under pressure UK investors head for the exit sooner or later. This time last year the GBPUSD exchange rate was 1.50, today it is 1.67. In sterling terms, the value of dollar-denominated dividends has fallen by 11%. This matters because approximately 60% of all FTSE 350 dividends are paid in dollars, not sterling, and the underlying exposure to overseas earnings is higher.

Our approach to asset allocation does not use forecasts, so we are not interested in the consensus forecasts for UK dividend growth. However other investors do care and will react if the forecast has to be reduced. We have no problem with the consensus of 0% growth for 2014, but we think that the forecast of 9% for 2015 is ambitious, especially if you believe that sterling probably has further to rise. We assume that the Bank of England will raise interest rates sooner and higher than either the Fed or the ECB.

There is a view that UK investors will have to grin and bear this because the alternative is equally unappealing. We are not so sure. We agree that gilts look unattractive over the medium term, but there is another asset class, which is well-regulated and well-researched, and which has returns denominated entirely in sterling. We speak of Commercial Property. Like everything else it is “overvalued” when compared with long-run averages – that’s what happens when interest rates go to zero. But it does have one thing going for it – rental growth. According to Cushman and Wakefield, a firm of international property advisers, prime London office rents will grow by 6.0% in 2014, and 6.5% in 2015. This is close to 13% over two years, already more than the 9% for dividend growth and that’s before the consensus gets cut.

We repeat: we don’t believe in forecasts. Equally we do not believe that UK investors will stay trapped in a binary choice between fixed income and equities. Commercial property may soon have its day in the sun. That may also make UK equities less attractive to overseas investors.

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