The FTSE All-Share retreated 10.2% over the period, falling sharply, inline with global equities. It was one of the worst quarters for global equities in many years as fears over the outlook for the world economy came to a head against the backdrop of tightening global monetary conditions, US-China trade tensions and European political uncertainty. Many UK domestic-focused sectors also performed poorly as worries of a "no deal" exit from the EU intensified after the UK published its draft EU Withdrawal Agreement (endorsed by EU leaders) which triggered another period of intense political uncertainty.
Several senior and junior ministers resigned in protest at the Withdrawal Agreement, raising questions over the stability of the UK government, and the final parliamentary passage of the deal. The prime minister struggled to gain sufficient support from parliament for the agreement in its initial form, with one of the main issues being the backstop arrangement to avoid a hard border between Northern Ireland and the Irish Republic. A "meaningful vote" on the agreement was deferred until January, in turn sparking a no confidence vote in the PM's leadership of the Conservative Party, which she won by 200 to 117.
Despite the uncertainty, and the risk of a UK recession in the event of a "no deal", the economy continued to recover from the very poor start to 2018. UK Q3 GDP growth came in at 0.6% quarter-on quarter as expected, up from 0.4% in Q2 and the fastest pace since Q4 2016. More recent data, however, has been volatile: UK retail sales disappointed in October, falling -0.5% month-on-month, but bounced back in November, increasing by 1.4% month-on-month, which was above consensus expectations. UK households enjoyed an acceleration in wage growth and lower inflation over the period.
We have discussed in previous quarters how global developments set the tone for UK equities and the market gyrations seen in the fourth quarter of 2018 are a timely reminder of this. The driving forces are international; including US-China trade tensions, European political uncertainty, and the end of quantitative easing/rising interest rates. On our forecasts, 2019 will be the first calendar year since the global financial in which liquidity will on aggregate be withdrawn from the global financial system. As markets digest this shift, it would not surprise us to see a continuation of the recent pick-up in volatility. Global trends like these remain crucial to the performance of UK assets. But so will Brexit, with many potential pitfalls in the run up to and beyond the UK's scheduled departure from the EU on 29 March 2019.
As stock pickers, these uncertainties can present opportunities that have been increasingly rare in the low volatility environment that has been present for much of the last decade since the Global Financial Crisis.
Brexit has resulted in UK domestic-focused companies significantly underperforming those companies that generate their earnings overseas. Sterling weakness has been a major driver of this as overseas earnings become more valuable when brought back to the UK when the pound is weak. However, the underperformance has also been in large part due to fears the UK economy would grow at a lower rate outside the EU.
Should a "no deal" Brexit be averted, there would likely be an upwards movement in sterling and a re-rating of the market. This would be particularly beneficial to those UK domestic companies that have suffered a severe de-rating over the last two and a half years. UK-focused banks, property companies, house builders, consumer discretionary areas (general retailers and leisure companies), food retailers and utilities are all trading on depressed ratings. This is clearly seen in a range of valuation metrics, including P/E ratios, which for some of these sectors are now in single digits.
In a no-deal situation, we would expect sterling weakness and a heightened risk of a near-term slowdown in the UK economy. In this scenario, many of these same domestically focused areas of the market would suffer. Heightened political risk and concerns over the impact of a potential Labour Government's policies would likely hit utility companies as well as some business services companies with government contracts, although some fears have already been priced in to shares. Those that would benefit from a no deal would naturally be UK quoted multinationals. Sterling weakness would boost their earnings, dividends and valuations.
The Fund’s NAV return underperformed the FTSE All Share Index over the quarter. Bookmaker William Hill was the largest detractor as it revised down expectations for full-year profits following the UK government crackdown on the gambling sector and on the back of increased investment in its US business. However, the company has the potential for material long-term growth as the US sports betting market de-regulates. This more than outweighs the nearer-term headwinds facing its UK operations and diversifies the business geographically as well as increasing exposure to the more attractive online sports betting market.
Shares in British American Tobacco (BAT) performed poorly on news that the US regulator the Food and Drug Administration (FDA) was considering banning menthol cigarettes, which represent 26% of group profit, whilst cracking down on the sale of flavoured e-cigarettes in order to address its concern of youth access to smoking. We believe the shares have reacted hastily as the legislative process will likely take several years and require relevant scientific evidence. BAT has both experience of mitigating regulatory changes as well as a range of reduced-harm products (such as heated tobacco and e-cigarettes) which have good growth potential. Our holding was based in part on the tobacco sector's defensive characteristics together with valuation appeal amidst the challenge of defensive stocks on rich multiples or more economically sensitive stocks vulnerable to a cyclical sell off. We continue to evaluate the situation and engage with management.
The industrials sector continued to perform particularly poorly amid uncertainty over the extent of the slowdown in global activity. Our industrials holdings in speciality chemicals company Johnson Matthey and defence firm BAE Systems detracted significantly. Worries over BAE Systems defence contracts with Saudi Arabia in the wake of the death of journalist Jamal Khashoggi in Saudi Arabia's Istanbul consulate in October added to negative sentiment.
In amongst the recent market volatility, companies with more defensive characteristics have been favoured most this quarter. We benefited from exposure to a number of them including telecoms firm BT Group, information and data group RELX and pharmaceutical GlaxoSmithKline. This was, however, in large part offset by our lack of exposure to other highly valued defensive companies such as beverages firm Diageo.
Publisher Pearson was among the better performing holdings as the US Higher Education business appears to be on a more stable footing and a recent positive trading update suggests the company is on track to meet full year expectations. Elsewhere, infrastructure developer John Laing continues to perform strongly, demonstrating the attractions of exposure to infrastructure investment at a time of economic uncertainty.
In terms of trading activity, we initiated a holding in Whitbread, the UK's largest operator of hotels, restaurants & coffee shops. The sale of its Costa Coffee assets to Coca-Cola for £3.9 billion, for a significant premium to market expectations, gives the remaining group meaningful financial flexibility to invest in its remaining business whilst maintaining a strong balance sheet. We expect to see continued expansion of UK hotels and an accelerated development in Germany, a relatively new opportunity for the firm, a bolstering of the pension fund and the potential for some enhanced shareholder returns. We believe that the market underappreciates the quality of the brand and the growth potential of the franchise due to fears over the prospect of UK consumer businesses in the face of Brexit. We have been prepared to take a more positive and longer-term view given the strength of the balance sheet and the business model.
|Q1/2018 - Q1/2019||Q1/2017 - Q1/2018||Q1/2016 - Q1/2017||Q1/2015 - Q1/2016||Q1/2014 - Q1/2015|
|Net Asset Value||5.2||0.1||19.5||-3.9||14.0|
|FTSE All Share Total Return||6.4||1.2||22.0||-3.9||6.6|
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