UK stock market viewpoint: Time to update old beliefsContributor Alex Dryden
UK equity indices are changing in nature and investors should re-evaluate their long-held beliefs about the nature of the UK market. Commodity sectors have a much smaller weighting in the FTSE indices than they did a decade ago and have been replaced with consumer-oriented industries that have more exposure to the UK economy. These changes will have a significant impact on UK investment strategies.
The changing face of the FTSE
Historically, UK equity benchmarks have been considered a proxy for the global commodity cycle, given their heavy exposure to that sector. However, the weighting of commodity sectors in the FTSE 350 index has fallen sharply in the last eight years. At the end of 2015, energy and materials accounted for just 15% of the index - down from 34% in mid-2008.
Commodity exposure is not the only area that has shrunk in recent years. As Exhibit 1 shows, the financial sector was 31% of the index in 2006, but now makes up just 21%. As the influence of the commodity and financial sectors has waned, the weighting of consumer-oriented sectors - consumer staples and consumer discretionary - has risen. In 2008, these two sectors accounted for just 18% of the market cap of FTSE All-Share. Today they make up 32% of the index.
Exhibit 1 Market weight in the FTSE 350
Source: FactSet, FTSE, J.P. Morgan Asset Management. *Consumer-orientated sectors include consumer goods and consumer services. **Commodity sectors include energy materials.
Data as of 16 March 2016
We do know that the significant shift away from energy and materials towards more consumer-oriented sectors means that many investors should re-think their long-held view of UK equity benchmarks. Not least because consumer sectors in the UK are more exposed to the domestic economy than the commodity firms that they share an index with.
Sector dispersion has widened in recent years
These changes in index composition are having important implications for active UK equity managers. We’ve already seen a significant dispersion in earnings and performance across FTSE sectors in recent years, with commodity-related stocks suffering a sharp downturn in earnings and consumer-related stocks benefiting from the domestic UK economic recovery.
The commodity slowdown has badly damaged valuations in energy and mining companies, many of which sit in the large cap space - which in turn explains some of the underperformance of large cap UK equities in recent years. By comparison, the relative strength of the UK consumer has pushed up valuations in consumer-oriented sectors. But the last 10 years have been rocky ones for consumer stocks, and perhaps do not offer a fair basis for comparison. With real wages growing and unemployment falling in the UK economy, there could be additional upside in cyclically oriented sectors.
Active management is key to navigate benchmark changes
Many fund managers have benefited from the decision to underweight commodity sectors, while moving active money towards stocks that are most sensitive to the UK consumer. Although UK large-cap benchmark indices are becoming more exposed to consumer sectors, investors looking to maximise their exposure to UK domestic economy need the flexibility to increase their exposure to small-cap and mid-cap UK equities, which typically have a greater exposure to the real UK economic recovery.
However, when the tide eventually turns on commodities, the focus will shift back to traditional drivers of outperformance: research-driven individual stock views, portfolio construction and risk factor management. Some managers will handle the change of direction a lot better than others.
Unless otherwise stated, all data is sourced FTSE, FactSet and J.P. Morgan Asset Management as at 16.03.16
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