Where should UK equity income investors be looking in 2017?

It is with some trepidation that I write about the outlook for this year. Before 2016, most commentators, me included, would not have predicted the Brexit referendum result nor Donald Trump's election victory.

Even more importantly, I would not have come close to estimating the market behaviour for the year, even if I had had perfect foresight about those events.

Having said that, certain things can be expected, the first being uncertainty itself. We have general elections in France and Germany and continuing uncertainty about how the UK's Brexit eggs will be cooked - hard, soft, or seductive but with a bitter aftertaste.

We also find out which Donald Trump we get, the outspoken one on the campaign trail or the pragmatic businessman.

Difficult to predict stockmarket behaviour

Secondly, protectionist measures are likely to become more prevalent and the globalisation trend may reverse somewhat. We are seeing a rise in populism across Europe and the US, as a result of a rising inequality and difficult circumstances for many.

We are also likely to see a change in economic policy, with fiscal stimuli being applied in the US, and to a lesser extent in the UK, in the form of infrastructure investment, defence spending and tax cuts.

Rising interest rates may choke economic growth, with consumers highly leveragedMonetary policy is likely to become less accommodating, with further gradual interest rate increases in the US and perhaps even in the UK.

Government bond yields have already increased markedly, even before the US election result. Volatility in rates is likely to be far higher than we have become used to, during a period of financial repression.

This all makes it difficult to predict stockmarket behaviour. It is possible to imagine a stronger stockmarket caused by hopes for higher economic growth and stronger profits growth, as inflation creeps back into the system.

Conversely, it is equally possible to predict the opposite. Rising interest rates may choke economic growth, with consumers highly leveraged. Brexit uncertainty could cause a hiatus in investment spending and consumption, possibly even leading to a UK recession.

Strong businesses

It is, however, still possible to build a portfolio for these circumstances. In an unpredictable environment, it is particularly important to pay attention to the fundamental qualities and valuations of companies.

We are looking to own strong businesses, priced at attractive valuations, from which investors can expect to earn a decent return over the mid-to-long term. Attractive valuation is particularly important, as it can provide downside protection in a difficult stockmarket environment.

Dividend growth should be relatively healthy, with market forecasts in the mid to high single digitsAlthough our remit is to invest in the UK's largest companies, it is worth emphasising the truly international nature of many companies that make up the FTSE 100 index - including some of the world's largest and best-known multinationals.

These companies offer global diversification without the need to consider non-UK equities.

In general, stocks with a high, sustainable dividend yield are likely to perform well. Interest rates will remain low by historic standards, even if they rise across 2017, meaning investors will continue to seek assets that produce a higher income.

Dividend growth should be relatively healthy, with market forecasts in the mid to high single digits.

Dividends will be boosted by recent sterling weakness, especially against the dollar, as UK-listed companies earn most of their money abroad, and many pay dividends in dollars or other foreign currencies.

Where is the value?

At present we see the best value in two major sectors of the stockmarket: "mega-caps" and recovery situations. Mega-cap stocks like GlaxoSmithKline, Royal Dutch Shell and HSBC are globally diversified, so not totally dependent upon the UK economy.

Whilst these shares performed well last year, they remain modestly valued on a long-term basis, reflecting previous issues in their business or challenging industry conditions.

In each case we can see why profitability should improve in the medium term, and why shareholders should make an attractive return, with a combination of a high yield and capital growth.

Recovery share prices often reflect the low level of current profits, rather than future profit potentialThe stockmarket of recent years has rewarded companies producing reliable, steady growth, by pushing their shares onto high valuations. Conversely, companies where profits are cyclically depressed, or going through a restructuring, are often lowly valued.

Recovery share prices often reflect the low level of current profits, rather than future profit potential, which will come through as earnings and cash flows recover.

Industries with cyclical recovery potential include construction and defence, where we own businesses like Balfour Beatty, Kier, BAE Systems and Senior. Restructuring situations include Ladbrokes Coral, First Group and retailer Marks & Spencer.

In summary, whilst the economic and market outlook for 2017 is uncertain, it is possible to find investments that should deliver reasonable returns to investors over the medium term.

We believe it is important to own a diversified portfolio of strong businesses trading on attractive valuations such as the global mega caps and the recovery situations listed above.

Simon Gergel is portfolio manager of The Merchants Trust.

 This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.