UK small- and mid-cap companies could emerge from this crisis a bit leaner. Thoughts on why this is encouraging by Richard Bullas and Dan Green.
As the United Kingdom falls under further social distancing measures to combat the coronavirus pandemic, what lies ahead for the UK economy? Franklin UK Equity Team’s Richard Bullas and Dan Green share their perspective, and what a slowdown in economic activity could mean for UK small- and mid-capitalisation stocks.
Given the improving UK economic outlook many of us previously anticipated for 2020 and beyond, the expected negative economic impact of the coronavirus pandemic on the UK economy has caught many investors by surprise. We had entered the year with optimism, given the recent UK election result and the government’s commitment to spending.
What’s been encouraging to us during this pandemic is the coordinated response between the Bank of England (BoE) and the UK government. The BoE’s decision to reduce interest rates to near zero—at the same time newly-appointed UK Chancellor of the Exchequer Rishi Sunak essentially promised a blank cheque to support the economy—is a concerted effort to move early and avoid anything similar to the panic we saw during the 2008-2009 global financial crisis.
The UK government is really living up to the mantra of doing “whatever it takes” to cushion those most vulnerable during this period by supporting the overall economy through National Health Service (NHS) funding, business support grants and job retention schemes.
While we don’t expect the UK government to solve all the nation’s problems, what it is doing is pumping cash into the real economy to cushion it though this period by supporting incomes and those business affected. We’re hopeful this economic slowdown could be temporary, but whether we see a sharp V-shaped rebound—marked by a rapid downturn and then rapid rebound from the trough—or a more gradual U-shaped recovery, remains to be seen.
RAMIFICATIONS OF A TRULY GLOBAL EVENT
The coronavirus is unique because it has affected so many people, businesses, governments and markets across the globe in a scale and scope we have never seen before.
What started as a supply shock in China that disrupted global business supply chains has now created a demand shockwave in the West. Economic activity in many cities or countries has all but shut, and a severe recession is now unavoidable.
But this hugely disruptive period will end. As long-term investors, we need to think about how the world will look and behave coming out of the other side. We believe this experience will have far-reaching implications for businesses, governments, society, consumer habits, demand patterns and working practices. We’ll be alert to any opportunities that emerge after this period.
We could see an acceleration of underlying structural trends in many industries, such as online retail, working practices and capabilities, and the network and data infrastructure that supports them. We may see a faster upgrade to a fifth-generation (5G) world through better communications infrastructure.
IMPLICATIONS FOR UK STOCKS
Unsurprisingly, many UK businesses are now in survival mode given that they are temporarily closed. This creates a cash flow crisis and the reality is some won’t likely survive the economic fallout from the coronavirus. Companies are being forced to remove financial guidance to shareholders, suspend dividends and buybacks, and cut costs to conserve cash.
Small- and mid-cap stocks have generally underperformed during the recent market crash relative to the wider market, primarily due to differing sector makeup—there’s a greater domestic bias for these types of stocks, which are more cyclical in nature. Many of these stocks have seen declines in the region of 30%-40% of market value, as a result of this “risk-off” period and a clamour for cash and poor liquidity.
Without a doubt, the sectors with the largest declines have been oil and gas, consumer discretionary and retail. Within these sectors, companies in travel and leisure—such as cinema chains, gyms and restaurants—have been hit particularly hard. The cancellation of major UK sporting events and the closure of some cross-country routes has also affected bus and railway companies. We’ve seen a selloff in the more cyclical names at the smaller end of the market, including housebuilding companies and those that are involved in the construction supply chain. Businesses within the financial sector have borne the brunt of the selloff, too.
ADAPTABILITY GOES A LONG WAY
As we would generally expect, companies with stronger balance sheets before the pandemic have been more resilient, such as health care and utility companies in the more defensive sectors of the market. Food retail and food producers, for example a leading UK pork producer, have seen extra demand due to customers stockpiling ahead of the shutdown but also consuming more food at home.
Other companies that are beneficiaries of this environment include video game producers. Unsurprisingly, online gaming platforms have reported an increase in video game consumption as people are forced to stay at home.
Our investment process means we are selective. We favour companies that meet our criteria of strong balance sheets and experienced management teams. Many businesses have shown they are adaptable in times of crisis and uncertainty—and those are the ones we think have the best chance to weather the crisis. Many of these businesses managed to survive the Brexit uncertainty not so long ago—we’d expect management teams to put the lessons learned from past experiences to good use for the foreseeable future, and emerge from the coronavirus pandemic to take advantage of the opportunities this will create.
WHAT ARE THE RISKS?
All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile.
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.
Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
