Prospects for the UK equity income sector

Hak Salih, manager of the Santander UK Equity Income Fund looks at the prospects for 2008.

Says Salih: “We favour larger companies, especially the mega caps, as they continue to look very attractive, driven by stable earnings prospects, strong balance sheets and growing dividends at attractive initial yields.

“Given the weaker outlook for the UK economy combined with interest rate cuts it is likely that we will see a period of Sterling weakness both against the Dollar and the Euro. Given the large exposure to overseas earnings of the FTSE constituents, this is another reason for the preference for larger caps in the UK. Mid and small caps in general remain unattractive due to their larger domestic and consumer exposure. However, as always in a market shakeout with indiscriminate selling there will be attractively priced opportunities for us to increase our exposure to these areas as the year pans out.

“Given the softer outlook for global growth we have significantly reduced our exposure to the mining sector compared to last summer’s overweight position against the income sector. The significant re-rating of the sector has left most valuations unattractive given the softening outlook for global commodities demand. However significant corporate activity is the last story to play out in this sector and our remaining exposure plays to this theme.

“We were underweight the banking sector in 2007, but reduced this as the steep price falls threw up very attractive yields, more so given that we expect UK interest rates to continue to be cut this year.

”We maintain our overweight position in oil stocks relative to the income sector. This is driven by the view that valuations are cheap relative to the current oil price, having not fully reflected the rise in crude oil prices, and that the sector is a cheap way to play global growth.

“Pharmaceuticals, in our view remain undervalued as they are relatively economically insensitive and we continue to build weightings in the sector. This sector is likely to benefit from the fact that concerns about the sector (the upcoming US election, low growth, patent expiries and lack of drug pipelines) have been largely discounted into existing prices, and that future earnings will benefit from any sterling weakness.

“Although prospects for the equity market in the next twelve months look unexciting we believe that we are unlikely to see the significant underperformance of the income sector that we saw last year. Instead, with falling interest rates and a positive outlook for higher yielding larger caps, we believe the income sector should be well placed for 2008.”