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Quarterly Letter – Q2 2022 – UK

Our quarterly note covering the UK

28/07/2022

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Have I been sleeping?

Kate Bush is number one in the charts. Inflation is at elevated levels, causing a cost of living crisis. Union action has crippled the country, with strikes from multiple trade unions bringing widespread disruption.

Is it June 2022?

Or is it February 1978 when Kate Bush was the first female artist to reach number 1 with a self-penned song, inflation was 8%, and it was the ‘Winter of discontent’? 

Investors overuse the phrase ‘history doesn’t repeat, but it does rhyme’. But in this case, history does seem to be repeating. Just as some investors appear to be repeating the same mistake that investors often make – mistaking an investment cycle for a new paradigm.

This particular cycle was a big one. Driven by investors’ infatuation with growth, fuelled by low interest rates, free money, and excessive risk tolerance, the UK market offered little in comparison to the glittering lights of the tech stacked US stock market. Investors rushed to reduce their exposure to the UK, deciding an allocation to global markets was preferable to the “dinosaur” and “moribund” stocks contained within the UK market.  This allocation was, of course, a back-door allocation to the over-valued US market which accounted for half of MSCI world in 2015, but by 2022, accounted for two thirds of the entire global benchmark.

In a rare demonstration of forecasting accuracy, our Q4 ’21 QIR concluded with “in the medium term, the UK has the potential to surprise positively, to be one of the strongest global markets from an income perspective [and] to be one of the strongest global markets from a capital perspective”.

Year to date market total returns

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Source: Schroders, Morningstar, as at 30 June 2022. Returns are net calculated in base currency for each index shown.

How has the UK achieved this? Through the things that are here, and the things that aren’t. It has large weightings in sectors that have been out of favour for the past ten years (banks, oil & gas and mining), all of which are now in demand as their cycle has turned, leading to profit and dividend growth.  On the flipside, the UK lacks a large tech sector (one of the reasons people went global), but it’s the tech sector which is dragging down global indices, with the S&P now in official bear market territory, and ‘non-profitable tech’ having it’s worst quarter ever. The combination of these two factors have led the UK to being one of the highlights of a difficult investing environment.

So where does that leave us going forward?

The UK’s performance over the past six months has been driven by some of the largest companies in the market. The Oil & Gas companies and the Mining companies are extremely large multi-national behemoths. Many of the UK banks are seen as globally systemically important. The entire market has been buoyed by a small handful of very large businesses (as an aside, this is why so many active managers have found it difficult to outperform this year). Whilst the UK market is marginally lower year to date in absolute terms, on a cap weighted basis the median company share price is down 18%. Another way to demonstrate that is to look at the performance differential between the FTSE 100 (the largest stocks in the market) and the 250 smaller stocks behind it.

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The differential in performance between the largest stocks, and the 250 stocks behind them is the greatest on record, reaching 3 standard deviations in May.

That differential means the opportunity set for our team of value investors is rapidly changing.

Stepping back from the UK for a moment and looking at markets more broadly, losses so far have been driven by a reduction in the profit multiple investors are willing to pay for companies. Earnings forecasts, in aggregate, have yet to move. If we take the S&P500 as an example, while the market is down, analysts currently believe corporate earnings will increase by nearly 10% in 2022, in 2023 and 2024.

Consensus estimates, S&P 500 earnings per share

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Falling prices with a static earnings forecast mean the US market’s cyclically adjusted PE ratio (CAPE) has declined from 38x at the start of the year to 28x today. However, what is happening, is not dissimilar to what happens at the start of every economic decline. Analysts tend to wait for companies to announce bad news before adjusting forecasts for fear of looking stupid if it doesn’t happen, while the market as a whole tends to react in advance of downgrades.

Higher interest rates will inevitably impact consumers. That is the entire point of higher interest rates. In an attempt to contain price increases, the Bank of England, the Federal Reserve, and the other Central Banks of the world need to reduce demand to better match supply and demand. The only tool they have is a very blunt one – interest rates. And if people have to lose their job to achieve price stability, Central Bankers believe that is a price worth paying.

As a consequence, the chance of inflation at 9%, and resultant higher interest rates, not having an impact on consumer spend is low.

So if the consumer is about to come under pressure, why have the most recent stocks we have bought all been UK consumer stocks? Because the stock market has moved in advance of the downgrades. As mentioned above, the median stock in the UK has fallen by 20%; the median retail stock has declined by 38% since the start of the year. (Source: Schroders, Eikon, as at 07/07/2022)

Although a potentially dangerous analogy for a variety of reasons, the current environment feels somewhat similar to the beginning of 2008 (please don’t take this analogy too far). In the first half of 2008, UK consumer stocks sold off aggressively in anticipation of an economic slowdown, whilst other areas held up as there was a belief that Emerging Markets (China in particular) would ‘decouple’ from the West. This time round, UK consumer stocks are selling off aggressively, whilst commodity focussed stocks are holding up due to forecasts of continued elevated demand for commodities driven by the forthcoming energy transition. Is history repeating, or only rhyming?

We don’t know. We have no greater insight into the likelihood of the energy transition propping up commodity prices as we did for China causing a decoupling. Just as we have no greater insight into the outlook for the UK economy than corporate managements, who came into 2022 with unprecedented levels of optimism (as shown by the OECD UK Business Confidence Index being at its highest point since data began in the 1970s). Just as we have no greater insight into the outlook for inflation than the Bank of England.

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However, sometimes in financial markets we are compensated for running into a burning building. Today, there are some areas of the market where we believe this to be true. To ensure portfolios are well-positioned at the bottom of whatever ‘this’ is, we need to buy in ahead of the downgrade cycle being complete. It is entirely reasonable to believe downgrades will come. But have shares moved to fully price that in? It’s impossible to say. It is also impossible to rotate the portfolio on a single day at the very trough.

Our job, as always, is to continually tilt the portfolio towards the areas of opportunity. That means we are rotating away from the stocks which have done well for us over the past two years, the mining, oil and gas and banking shares. We are increasingly looking at the more domestic facing cyclicals, but only where balance sheets are strong enough to withstand potentially tough times. Each purchase we have made so far has immediately looked naïve. The fear of looking naïve ensures few of our competitors will follow suit. This, however, also ensures we will be one of the few to benefit once ‘this’ is over. In the interim, while ‘this’ may be uncomfortable, ‘this’ will allow us to lay the foundations for the performance of the funds over the next five years.

 

Author

Important Information:

The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German, Tom Biddle and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.