As the monetary support that has lifted the UK equity market since March 2020 is withdrawn, we expect company fundamentals to be key.
14 Jan 2022
These are exceptionally interesting times for UK equity investors. As the market moves off fiscal and monetary support, investors are questioning what happens next. When will the pandemic end and what will the lasting impact be? How persistent will inflation prove to be? Where will interest rates go from here? Is the recovery in economic growth sustainable? How permanent are the scars caused by Brexit? Are debt levels manageable? Which companies are best placed for this new paradigm? These are just some of the questions weighing on investors’ minds. We believe there is likely to be a significant change in the drivers of UK equity market performance from here and company fundamentals will be key.
Since the pandemic-induced market lows in March 2020, the environment for investing in UK equities has been incredibly supportive. UK base rates were reduced to a mere 0.1%. Quantitative easing (QE) was accelerated with £450 billion of additional net asset purchases by the Bank of England, supporting UK government borrowing that funded record levels of fiscal stimulus. A majority Conservative government, following the December 2019 election, and the subsequent ‘conclusion’ of Brexit negotiations in January 2020, seemingly removed much of the political uncertainty in many investors’ minds that had weighed on UK sentiment in recent years. In addition, one of the most successful vaccine rollouts globally enabled the quick release of pent-up consumer demand, as lockdown restrictions were eased, leading to a rebound in UK GDP growth of 5.5% in the second quarter of 2021.
These are exceptionally interesting times for UK equity investors. As the market moves off fiscal and monetary support, investors are questioning what happens next. When will the pandemic end and what will the lasting impact be? How persistent will inflation prove to be? Where will interest rates go from here? Is the recovery in economic growth sustainable? How permanent are the scars caused by Brexit? Are debt levels manageable? Which companies are best placed for this new paradigm? These are just some of the questions weighing on investors’ minds. We believe there is likely to be a significant change in the drivers of UK equity market performance from here and company fundamentals will be key. As a result, although a relative laggard against its developed market peers, the UK equity market nonetheless returned over 60% from its trough in March 2020 to the end of 2021, surpassing its pre-pandemic highs. We’ve seen a significant increase in M&A activity, IPOs, retail investor participation in markets and trading activity in 2021, as well as a resumption of dividend payments from many companies that were forced to cut their payouts in 2020. Value and growth styles have competed for leadership of this ‘risk-on’ market as investors have respectively bet on the recovery being sustainable and inflationary forces being transitory. Conversely, defensive quality compounders, while in many cases also up handsomely in absolute terms, have largely lagged the rebound. The big question, however, is whether this will continue?
We strongly believe that we are at an inflection point in the UK and it is highly likely that what has led the market in the previous 18 months will not lead the market again over the next 18 months and beyond. Supply chain bottlenecks, higher energy, raw material, food and transportation costs, labour shortages, higher wages and increasing consumer demand have all combined to push inflation above 5% in the UK, its highest level in more than a decade. With inflation proving to be less transitory and more persistent than originally expected, the Bank of England has now changed tack on monetary policy, recently raising rates, initially to 0.25%. GDP growth fell back below expectations to 1.3% in Q3 2021 and the recent rapid spread of the highly transmissible Omicron COVID-19 variant has likely further stalled the nascent recovery.
Furthermore, in its October 2021 ‘Economic and fiscal outlook’, the Office for Budget Responsibility was already forecasting lacklustre medium-term GDP growth, with an average forecast annual growth rate of just 1.5% in the years 2024-26. QE has not driven higher growth as it has solely funded government borrowing since the pandemic. With the ending of the Bank of England’s asset-buying programme and a large debt and deficit burden for the government to manage, the room for political manoeuvre is significantly curtailed and we believe that fiscal tightening is now inevitable.
Against this more uncertain and challenging backdrop, and with equity markets around the world at elevated levels, we believe caution in portfolio construction is prudent. Similar to 2019, we don’t believe in chasing the market higher at this point, particularly as markets move off liquidity support, governments tackle their significant debt burden and the scars of both COVID-19 and Brexit remain. While value and growth stocks have led the risk-on trade in the UK, we believe there is increased recovery risk in the former and increased valuation and inflation risk in the latter. Conversely, given their inherent pricing power, balance sheet strength, low capital intensity and low sensitivity to the economic and market cycle, we believe high-quality defensive compounders are well positioned for the uncertain market that, in our view, lies ahead. Despite being largely out of favour in a market that has chased growth stocks and lower quality cyclicals, many of these quality businesses continue to display strong fundamentals.
It is highly likely that what has led the market in the previous 18 months will not lead the market again over the next 18 months and beyond
Two of our existing holdings that we think have been overlooked by the market, but present highly attractive opportunities from here, include Unilever1 and the London Stock Exchange Group (LSEG). Unilever’s valuation looks compelling given the market has questioned its ability to maintain growth and margins in an inflationary environment. Recent results, however, indicate that it is successfully passing price increases on to consumers. Strong brands, pricing power, low economic sensitivity and attractive valuations together provide a very powerful combination in what are likely to be more challenging markets ahead.
LSEG, on the other hand, is undergoing a transition as it digests its acquisition of Refinitiv, which we believe cements its position as the market-leading financial market infrastructure and financial data provider. With 70% recurring revenues, serving structurally growing markets with high barriers to entry, we believe LSEG is one of the highest quality businesses in the UK and represents an extremely attractive investment opportunity at current levels.
Following strong relative performance in 2020, the UK Alpha strategy underperformed a sharply rising market in 2021. Although mostly contributing positively to performance prior to the COVID-induced market lows, a number of companies in our strong franchises and defensive growth categories subsequently underperformed the recovery. As above, however, we would expect these more defensive compounders to lag this type of ‘risk-on’ market.
Many of these companies have also been impacted by events that we believe will be short-term or one-off in nature. Through its impact on travel, elective hospital treatments, global supply chains and input costs, COVID has caused material disruption to the likes of Smith & Nephew, Ryanair and Sabre Insurance. Nonetheless, we expect this disruption to be temporary and for these businesses to recover as conditions ultimately normalise. Separately, we believe events such as LSEG announcing increased investment in Refinitiv and GB Group completing a placing to fund a strategic acquisition, while negatively received by investors in the short term, will actually better position these businesses for longer-term growth.
Strong brands, pricing power, low economic sensitivity and attractive valuations together provide a very powerful combination in what are likely to be more challenging markets ahead
We continue to apply our established rigorous process and diversified approach, focusing the UK Alpha portfolio on seeking attractively valued businesses that generate cash and are able to reinvest that cash at high rates of return to self-fund long-term sustainable growth. Where we do own cyclical companies, our preference remains for select quality companies with an attractive combination of valuation support, self-help opportunities, improving industry dynamics and/or strengthening competitive position. One such example is speciality chemicals and sustainable technologies company Johnson Matthey2, which is trading at historical lows despite having a clear trajectory of future cash generation. The company has taken a strategic decision to simplify its business, exiting capital intensive eLNO (battery) technologies and focusing on higher ROIC opportunities in hydrogen. Although early days, we see increasing evidence of the competitiveness of its hydrogen technology and we retain our conviction in the long-term outlook for the company. Overall, we expect economic challenges to remain during 2022. However, post pandemic normalisation could see some areas of the economy improve, such as travel and leisure.
We continue to seek attractively valued businesses that generate cash and are able to reinvest that cash at high rates of return to self-fund long-term sustainable growth
Against a continued deeply uncertain backdrop, the UK Alpha strategy is defensively positioned and remains true to its investment philosophy — seeking attractively valued, quality businesses with strong financials and management, which can deliver long-term sustainable growth. The Strategy aims to remain diversified by stock, sector and style, with a quality bias to help navigate the continued volatility. We remain confident in the Strategy’s long-term holdings that have served us well over many years. Although some of these holdings have experienced short-term relative performance headwinds, as the tide turns, we believe these companies are well-placed to navigate the choppier waters of geopolitical stress, economic uncertainty and structural change that potentially lie ahead.
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