UK equities fell into bear market territory along with many other global stock markets as efforts to deal with the coronavirus pandemic hit economic activity indiscriminately and simultaneously. Prior to these events, domestic politics and Brexit had dominated the narrative around UK assets. At the height of the market sell-off – which occurred at record pace – all assets (including government bonds) fell amid fears around the stability of the financial system.
It was against this backdrop that sterling hit multi-decade lows in mid March versus the US dollar as investors sought safety in cash, particularly the US currency. In line with other central banks, the Bank of England materially reduced base rates, cutting by 65 basis points to 0.10%. This response was co-ordinated with the UK government, which unveiled an unprecedented series of fiscal support measures, in line with initiatives by many other developed nations.
Oil and gas was the worst performing industry grouping over the period, selling off on concerns about falling demand in the wake of the virus and the failure of negotiations between OPEC and Russia to control the global supply of oil. The consumer services grouping also performed very poorly as investors sought to calibrate the effect of a precipitous fall in consumer demand as the UK and other governments introduced lockdown measures.
UK small and mid-cap (SMID) equities markedly underperformed large caps over March
UK equities underperformed other regions over the quarter – according to analysis by Morgan Stanley Research, UK equities ranked 12th out of 16 regions based on Q1 price performances in US dollar terms. Sterling performed poorly versus the US dollar – while the currency quickly retraced much of the precipitous fall experienced in mid March, it still ended the period lower. As a result, a large part of its gains against the US currency since the summer of 2019 have now been erased. Sterling had recovered in the run up to and following the Conservative Party’s landslide general election victory in December and the consequent reduction in Brexit uncertainty.
Domestically-focused areas of the UK equity market experienced a similar reversal over Q1, which resulted in UK small and mid-cap (SMID) equities underperforming – the share prices of many of these companies halved over March and were a significant contributory factor to the FTSE 250 (ex Investment Trusts) index underperforming the FTSE 100 by more than 10 percentage points(pp) over the month (see table, above). These trends were particularly detrimental to funds with above average weightings in these areas and positioned to benefit from a recovery in UK economic activity, which had been in evidence right up until UK lockdown measures were implemented at the end of March.
Specifically, mid cap travel & leisure companies, household goods & home construction businesses and general retailers fell sharply as the government locked down activity in order to prioritise public safety. Mid cap companies in these three sectors collectively detracted 10pp (source: FactSet) from the performance of the FTSE 250 (ex Investment Trusts) index over Q1, when the index fell by 33.7%. By contrast, large cap companies in these three sectors detracted 3pp (source: FactSet) from the FTSE 100 over Q1, which fell by 23.8%.
Our largest individual detractor was not owning Pennon – at the height of the market sell-off the company agreed to a bid approach for its waste recycling business Viridor from US private equity group KKR.
More generally, fund performance suffered from our overweights in domestically focused areas of the UK equity market. As discussed above, these areas performed very poorly over March as global equity markets fell into bear market territory as efforts to deal with the coronavirus pandemic hit economic activity indiscriminately and simultaneously. Events moved very rapidly as the World Health Organization confirmed a pandemic on 11 March and on 23 March the UK introduced lockdown measures. As a result, the prospects for the UK economy reversed suddenly, which is perhaps best illustrated by the fate of the country’s housing market. House prices were on an upward trend right up until the very end of March when the government brought the market to a complete standstill.
Equally sudden stops in other areas such as non-essential retailers, airlines, restaurants and pubs underscores the acute challenges facing many consumer areas. As a result, our overweights in housebuilders Crest Nicholson and Redrow and casual dining specialist Restaurant Group were among the fund’s largest detractors. The latter reported strong like-for-like sales growth of 4.5% for the first eight weeks of its new financial year when the business had been unaffected by coronavirus. The share prices of all three companies fell by more than 50% over March. Our large position in general retailers also detracted, although the negative impact was lessened by petcare specialist Pets at Home which delivered a very resilient performance (see below).
Serviced office space specialist IWG performed very poorly, the shares dropped 51% over March, as many countries where it operates introduced lockdown measures. The balance sheet is stronger than it’s been in a long time, with financial leverage much reduced as a result of progress with transitioning to a franchise model. IWG has taken precautionary measures of not paying the declared final dividend for 2019 and suspending the £100 million buyback programme. In our opinion, the extreme share price reaction has been sentiment driven. The group appears to have been incorrectly categorised with others that have weak balance sheets so unfairly punished as investors abruptly moved in March to a “glass half empty” approach to company finances. We are reassured by IWG founder CEO Mark Dixon’s material stock purchases in March.
Our positions in exploration and production businesses Cairn Energy and Premier Oil also suffered sharp share price falls in March as crude oil prices collapsed to near 20 year lows following the failure of OPEC and Russia to agree on supply cuts. Oil prices have subsequently staged something of a recovery following the period end as the US attempts to bring together OPEC and Russia for talks.
On the positive side, Pets at Home was out top individual contributor. It performed well at the beginning of the quarter on the back of a very strong Xmas trading update. Shares also performed well towards the period end after veterinary surgeries and pet shops were deemed essential retailers. Retail derivatives platform provider IG was also resilient, being a beneficiary of the extreme volatility seen over the quarter – equity market volatility hit levels last seen during the global financial crisis (GFC).
Meat processor Cranswick performed very well reflecting changing meat protein consumption patterns resulting from the UK lockdown measures. The company supplies pork and poultry products to the whole spectrum of UK grocers, from the discounters (Aldi and Lidl) to the top-end (Waitrose) and the big four supermarkets in between. The enforced shift from out-of-home eating (restaurants) and wholesale (such as school catering) to retail is likely to benefit Cranswick,
Meat protein is proving to be some of the supermarkets’ fastest-moving lines at present so is ranking highly in the competition for shelf space given a focus on availability. If UK schools don’t return until the autumn and summer holidays are taken inside the UK (when the food industry usually sees a summer lull), a pick-up in demand could be well underpinned. In addition, the company’s pork products are enjoying strong demand in China, where domestic supply lines have been impaired due to African swine fever.
Cranswick has a strong balance sheet and is likely to maintain dividend payments at a time when even financially robust companies are suspending pay-outs. UK multi-utility specialist Telecom Plus was resilient for similar reasons and because of its defensive utility exposure.
Defence technology group QinetiQ was another top contributor following a reassuring Q3 trading update, which was in line with expectations. The update revealed good ongoing progress with the expanding UK test and evaluation business, US robotics and space products. QinetiQ has promising growth prospects, continues to benefit from self-help measures and is underpinned by a strong (net cash) balance sheet. The recent purchase of US-based Manufacturing Techniques (MTEQ) is particularly interesting. MTEQ’s expertise in sensors fits well with QinetiQ’s strong robotics and AI capabilities. The transaction has doubled operations in America, increasing US revenues to c.25% of group revenues. It is a good step towards QinetiQ’s goal of sourcing 50% of revenues from international customers. The US is the largest defence market in the world, so it also represents a very good growth opportunity.
We exited our holdings in private debt, equity and credit specialist Intermediate Capital Group (on its promotion to the FTSE 100) and insurance and travel group Saga, which was a residual position.
UK SMID equities have outperformed other areas of the stock market over the long term. We expect this trend to continue. In a rapidly-evolving world, SMID companies are generally better able to capitalise on new opportunities as they tend to be more dynamic, and have a smaller base than their large counterparts have from which to achieve growth.
We could see “domestic champions” emerging following recent events, with the financially stronger companies well placed to consolidate their positions. Governments are concerned that strong businesses survive this crisis, as underlined by unprecedented fiscal support packages across developed countries.
Schroders economists are forecasting a relatively rapid bounce back with the recovery to follow a “V-shape” pattern (see: V, W or L: what shape will the recovery take?) as the crisis abates, lockdown measures are lifted, business restarts, shops re-open and normal activity resumes. The key risk to this scenario is a potential return of the virus in the third quarter of this year, resulting in further lockdowns.
The UK is already well on its way to fiscal expansion and with a strong majority government in place and five years before the next election, it is well positioned to continue down this road. A backdrop of fiscal expansion is not only very different from anything we’ve seen over the past decade.
We will continue to seek companies demonstrating organic growth and pricing power where possible, and to avoid companies with too much debt. Disruption continues to be a feature for a lot of companies, putting pressure on earnings for a number of sectors, and we will therefore endeavour to identify and avoid these companies.
|Q1/2015 -Q1/2016||Q1/2016 - Q1/2017||Q1/2017 - Q1/2018||Q1/2018 - Q1/2019||Q1/2019 - Q1/2020|
|Net Asset Value||5.4||12.3||9.2||0.7||-25.3|
|FTSE 250 ex Investment Trust TR||2.2||13.6||5.6||-0.9||-21.2|
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