Across our funds and portfolios, we continue to favour cheaper equity markets, including Europe, Japan and Asia/emerging markets, rather than the expensive US. We are now increasingly comfortable favouring the UK as well.
We see the UK as a solid bounceback candidate for the simple reason that if we get a strong economic recovery, global investors will look for areas that have underperformed in the hope of a bigger rebound. As an exception to the overall equity exuberance, the FTSE 100 Index suffered its worst year since 2007 with a 14% decline.
The economic outlook also remains weak, despite the encouraging progress of the vaccine rollout, and the UK is among the regions where the International Monetary Fund predicts activity will likely remain below pre-pandemic levels until 2022. After a bounce in Q3 last year, renewed lockdowns have sent service activity – which constitutes the majority of the GDP – into negative territory again, dragging down the composite Purchasing Managers Index well below 50. Government consumption (healthcare and education spending) pulled fourth-quarter GDP up to a better-than-predicted 1.2%, avoiding the dreaded double-dip recession, but the overall 2020 decline of 9.9% leaves the economy back at 2013 levels and it should be noted that the second national lockdown only came into force right at the end of the year.
Meanwhile, the furlough scheme, extended once again in this week’s Budget to the end of September, is clearly masking the true unemployment picture. One thing we have seen in recent years, however, is that a healthy macro backdrop is not a prerequisite for decent equity performance.
Before examining the potential for a rebound, it is important to understand why the UK had such a poor 2020, and there are three core reasons. First is the structure of the UK market, which remains heavily weighted towards financial services and commodities, although both are proportionally smaller now after energy fell 40% and banks nearly 35% over the course of last year.
Why was there such a large decline in these areas, falling considerably more than more obvious Covid candidates such as travel and leisure? For energy, there was the OPEC Plus spat in March 2020, which was resolved relatively quickly but did considerable damage to the oil price. Recovery has also slowed as the future of oil companies is uncertain: many need considerable investment to transition to greener businesses and the core of what they do is increasingly coming under question. For financials, banks were prohibited from paying dividends in 2020 in case they needed extra padding for non-performing loans, especially in the event of a hard Brexit. There have also been concerns over life insurance around solvency ratios and potential defaults in their credit investments.
These two worst-performing sectors make up almost 40% of the FTSE 100 whereas the Index has just 1% in technology. In contrast to the much-feted FAANGs, the UK has no large tech stars and our representatives in this sector are considerably more functional: accounting software for smaller business or oil services tech, for example, rather than social media or other ‘stay at home’ leisure stocks. Compared to the US, with around 25% in technology, a key reason for UK underperformance in 2020 is the fact the market is highly exposed to value sectors and other areas that were shunned last year as the dichotomy between growth and value (which had been brewing for years) really came to a head.
Second is the dreaded B word, with uncertainty around Brexit and the terms on which the UK would ultimately leave the EU serving to keep a lid on returns since the referendum in 2016. In 2020, investors were conscious we were nearing the end of the process and the risk of leaving without a deal started to crystallise in people’s minds. This led to periods of the UK market selling off, or barely participating in what were effectively ‘better-than-expected Covid news’ rallies, due to stalled talks, missed deadlines and repeated stalemates.
Third, it is arguable that the UK has suffered more from the pandemic than the rest of the developed world bar the US. Prime minister Boris Johnson has not shone during the crisis, going late into the first lockdown and offering mixed messaging throughout, and the worst mortality rate in Europe is hardly an inspiring profile for foreign investors. The UK is not unique in facing prohibitive lockdowns but the combination of a service-driven economy (slightly more so than the US, for example) and falling levels of spending on and employment in travel and leisure has left the country vulnerable to their impact.
The positive view of the UK is that many of these factors are already in the rear-view mirror and it feels like most of the negative surprises are known and priced in, bar any lull in vaccine rollouts or further mutations in the virus. The most significant of these is that a Brexit trade agreement was eventually signed and while the full ramifications of leaving the EU will only become clear in the months and years ahead, the deal struck on Christmas Eve was symbolic enough to lift the prevailing cloud of uncertainty. This alone could be enough to spark a rebound as UK equities mean revert. Political events in the US are also a positive, with Joe Biden expected to be a far more predictable and rational President than his predecessor.
Our positive view of the UK, however, largely hinges on vaccine success, with the country potentially benefiting more from an efficient rollout as it has been harder hit. We know newsflow around this will continue to be volatile; nevertheless, the UK was early to order and, at the time of writing, is reported to be on track to meet the government targets.
If Covid-19 cases, mortality and hospitalisations continue to fall, leading to the ending of the lockdown, the UK will look more investable, especially at current attractive valuations. Once global investors have confidence in a recovery, it is natural to seek more risk and buy beaten-up stocks, of which the UK has many. M&A also started to pick up last year and we would expect this to continue, both from international players and well-capitalised UK names.
The UK currently has one of the highest saving rates in the developed world, which could support a rise in spending when non-essential shops open or serve as a cushion through a further downturn. A big consumption boom is not our base case but we should see some pick up in holidays, for example, once travel restrictions are eased. Additionally, we have a supportive central bank willing to implement further quantitative easing, a government ready to bring in more targeted fiscal stimulus, and potential enhancements to Brexit trade deals although it may be clutching at straws to hope for the latter in 2021.
In terms of our positioning, we were neutral on the UK for much of last year but started to move overweight in November on the back of growing vaccine optimism, as well as increasing exposure to small caps as we approached the end of the Brexit transition period.
We own Majedie UK Equity to have exposure to quality value, with the managers willing to hold international companies, snapping up Etsy for example. We also hold JOHCM UK Equity Income, which has a strict yield requirement and has tended to be overweight in small-cap domestically focused companies over the last few years.
From the same asset manager, we hold JOCHM UK Dynamic, an all-cap fund that has strict criteria around when it will buy companies (there must be some evidence of self-help commencing) and controls around sectors for diversification purposes.
Balancing these, we favour Lindsell Train UK Equity and Evenlode Income for high-quality growth. Both held up well last year through their exposure to companies with proven track records of generating high and consistent returns on equity, typically consumer staples, select media names and financials (ex-banks and insurers), as well as businesses embracing and using tech to their advantage.
Key Risks
