Fidelity: UK equities - down but not out

Key points

• We remain selective and favour companies with lower levels of debt and the resilience to navigate an uncertain macro environment.
• While financials form the biggest part of the portfolios, we have been taking some profits over recent months after particularly strong returns from companies in the sector.
• The smaller end of the market cap spectrum has derated indiscriminately due to recession fears. This is creating opportunities among companies where valuations have become detached from fundamentals.

UK equities have remained volatile so far this year as a combination of weak economic data, elevated inflation and sharply rising interest rates have raised concerns over the near-term outlook.

Despite this tough macro picture, we have been pleasantly surprised by the earnings resilience of our portfolio holdings, particularly given that we had moved to materially reduce our consumer exposure last year. This included selling out of housebuilders and cutting positions in areas more susceptible to a demand slowdown.

These decisions positively contributed to performance this year given profit warnings in those industries, with the housing market experiencing a marked slowdown. However, the profit warnings have not been as widespread as feared and in general the consumer has proved relatively resilient, helping the likes of Marks & Spencer, travel companies and airlines beat earnings expectations. This reflects economic indicators that have been weak, but not excessively so.

Staying vigilant given macro uncertainties

While there is increasing talk of a soft landing, there is considerable historical evidence on the impact of monetary tightening to keep us cautious on company prospects in the near-term. We remain selective and favour companies with lower levels of debt and the resilience to navigate the uncertainty. The weaker economic environment is likely to remain challenging for the time being, especially for those corporates and consumers in need of debt refinancing. Gearing remains low, reflecting our cautious stance and our desire to keep some powder dry to take advantage of opportunities and any forced sellers.

While financials form the biggest part of the portfolio given very attractive valuations, we have been taking some profits over recent months after particularly strong returns. Higher interest rates have allowed banks to significantly improve their profitability at a time where earnings in many industries are under pressure. However, we are approaching peak rates, which is likely to lead to peak net interest margins. Our holdings within the sector remain diversified in terms of geographic and banking model exposure, with idiosyncratic factors driving their growth.

The rising rate environment has also been positive for life insurers. While their earnings should continue to benefit from an acceleration in the pace of pension fund re-risking, we have reduced our exposure by selling our holding in Legal & General on near-term concerns over their fund management business and exposure to real estate. We have redeployed some of the proceeds into non-life insurance, adding to our modest exposure given the improving pricing environment and moderating cost of insurance claims.

Elsewhere, we have recently increased the exposure to non-financial GDP sensitives, as weakness in areas such as industrials is creating interesting investment opportunities.

Small-cap opportunities

The smaller end of the market cap spectrum is particularly rich in investment opportunities given the lack of research coverage. For us, this has always been a big structural overweight, and is an area where we are finding opportunities at the moment. Smaller companies have incurred severe deratings over the past year as they are thought to be more cyclical and thus more susceptible to an economic slowdown or recession. However, some of the share price declines, in our opinion, have been indiscriminate.

All in all, the relative attractiveness of UK valuations versus other markets - as well as the large divergence in performance between different parts of the market - continue to create good opportunities for attractive returns from UK stocks on a three-to-five-year view.

Undoubtedly the uncertain economic environment has negatively impacted the fundamental operating environment for some companies, but not all. Indeed, we think there are still reasons to be positive on the outlook for the companies we hold in the portfolio, which have significantly lower levels of debt, possess the strength and resilience to navigate a tough macro environment.

Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The Fidelity Special Situations Fund and Fidelity Special Values PLC can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. The shares in the investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.