UK stocks have rallied considerably over the past year, and anyone who was brave enough to back the market before the Brexit vote has made great gains.

But the bull market has hidden a number of threats to both the UK economy and domestically focused stocks, says Securities Trust of Scotland (STS) fund manager Mark Whitehead.

“There has been a rise of ‘animal spirits’ among investors over the past 12 months,” he said. “But we have had bombshells along the way. Weak sterling has sent stocks higher but returning inflation will impact consumers and corporates. Companies will have to spend more on products just as households will”

Whitehead says certain equities will be protected from the dangers of inflation, including real estate, energy stocks and utilities.

There is also the potential for economic impact; the UK’s current account deficit is funded by international money. If goods are less cheap in the UK and that flow of money stops, there will be trouble.

Other threats include the potential for a second Scottish referendum, and the fiscal and trade deficits that could result from Brexit – as well as grumbling geopolitical risk in Russia and the Middle East and a tenuous relationship with the new occupier of the White House. There are plenty of potential pitfalls for UK shareholders.

Is the UK Market Really International?

“UK equity investors will often tell you that you are not buying the UK economy when you buy a FTSE 100 company – as their revenues are international,” said Whitehead. “It is true that 70% of revenues for FTSE 100 companies come from overseas. But this is not the case for income investors. There is a lack of diversity within UK dividend paying companies – and this leads to concentration risk.”

Whitehead argues that a global remit has natural advantages for income investors, and he has the stats to prove it. The top 20 dividend stocks of the FTSE All Share account for 64% of the total pay-out. Widen this to the MSCI Europe and the figure drops to 39%. For the MSCI World Index the top 20 dividend stocks pay out just 18% of the total.

Not only is there stock specific concentration risk in the UK market, but these stocks are all grouped into just three sectors too; financials, consumer goods and oil & gas. Arguable two of these three are on shaky ground when it comes to dividend sustainability – the banks, who are liable to interest rate risk, and oil and gas which has seen input pricing fall in line with the oil price over the past three years. Oil and gas stocks are currently yielding more than the FTSE average, but investors should be wary of this headline figure.

Higher yielding companies are more likely to cut dividends, with stocks yielding between 9-10% on average cutting their pay-outs by 25% over the past 10 years. Even those yielding a more modest 5-6% have on average cut their dividend by 5% over the past decade.

“The ability to go global give you more opportunities,” says Whitehall. Securities Trust has 12% of the portfolio in UK stocks, 50% in US stocks, 13% in Asian equities and 19% in Europe, alongside small allocations to Latin America and Canada.

Source: Morningstar. Emma Wall | 13/04/2017

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