UK banks, retailers and real estate companies are the best placed to benefit from a domestic recovery, while British companies in the energy and travel & leisure sectors offer the greatest potential to climb on the back of the global economy. Those are the key findings of a new report from Bank of America Merrill Lynch, in which the authors note that recent data are all pointing to the UK recovery picking up pace.
Following the British economy’s 7% contraction from peak to trough in the 2008/09, and the resultant four years of a measly annual growth rate of just 1%, the investment bank sees consumer confidence, Purchasing Managers’ Index readings and credit conditions all improving, such that BofA Merrill Lynch now expects the UK economy to grow by 2.2% in 2014. “The squeeze on household income remains a headwind,” European Investment Strategist John Bilton and colleagues wrote, “but with the eurozone also emerging from recession and home prices rising, the UK recovery is gaining momentum.”
This forecast for the UK economy is marginally ahead of consensus, which currently points to GDP growing 2.1% next year—a raise on the previous month’s consensus of 2.0% and thus a clear indicator of improving sentiment.
For the UK stock market, BofA Merrill Lynch has maintained its FTSE target of 7,100 points for mid-2014, and introduced a target for the full year of 7,400 points, representing a 13%--or 830 points--increase from current levels. Should the FTSE 100 hit this target, it will have succeeded in more than doubling since the market trough in March 2009 and adding another 10% to its pre-crisis levels.
Within the UK’s $3.3 trillion stock market, the investment bank points to companies from the banking, retail and real estate sectors as the “best plays for a UK recovery”.* However, the UK market’s domination by global mega-caps with a ‘quality’ and ‘defensive’ tilt—the Vodafones, GlaxoSmithKlines and British American Tobaccos of the world—leads the BofA Merrill Lynch analysts to highlight the broader FTSE 350 sectors as more representative of the underlying UK economy. Among large caps, it is the banks that are the best proxy for ‘UK plc’, the report states.
Preferred* UK Sectors for Playing the UK Recovery
Banks: “Our ‘overweight’ on Banks is primarily driven by the improving macroeconomic environment. Housing market, credit conditions, consumer confidence and mortgage markets all warrant an improving banking sector. Additionally, UK banks have repaired their balance sheets to a larger extent than some of their European counterparts. According to our sector analysts, UK banks with a greater mortgage book should come out as clear winners. Banks with more international exposure may get dwarfed by an emerging market slowdown, while those with domestic exposure should outperform.”
Retail: “The sector’s capital employed has been consistently rising since 2004 and has more than doubled in the last decade. This trend is expected to continue and the scope for higher returns on an increasing capital base drives our ‘overweight’ rating on the sector.”
Real Estate: “We believe that the combination of inexpensive valuations, gearing to a rebound in property prices, scope for a pickup in occupancy rates, and Gilt yields rising only at a grinding pace create a solid backdrop for the sector to re-rate.”
Preferred* UK Sectors for Playing the Global Recovery
Business Services: “Business Services has profit margins below average, but good efficiency ratios – return-on-equity is well above market average, meanwhile earning-per-share growth is above average in both 2013 and 2014. Due to good value generation prospects, and low multiples, we assign an ‘Overweight’ to the sector.”
Energy: “The sector’s EPS growth picks up significantly in 2014 yet valuation metrics are deeply discounted relative to the market and free cashflow yield is above the market average. We see Energy as a deep value sector in the UK and Europe and rate the UK sector an ‘Overweight’.”
Telecoms: “Given the bias against quality styles, telcos’ low rank on all quality metrics suggests that the sector could perform well as the ‘down in quality’ theme takes hold further; overall we rank the sector an ‘Overweight’.”
Travel & Leisure: “EPS growth is strong for Travel & Leisure even though margins are below average; price-to-book multiples are rich but price-to-earnings are closer to average. There is some vulnerability on leverage ratios. However, with cash realisation ratios higher than the market, we see no immediate concern over this.”
Find stocks from each of the 11 Morningstar sectors by clicking here.
*BofA Merrill Lynch’s valuations are based on its CROCE-WACC analysis—Cashflow Return on Capital Employed less Weighted Average Cost of Capital; aggregated from individual company data—with the exception of the financials sector, which it assesses via the combination of more traditional valuations and a strategic sector view.
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