‘Much has changed, but a lot remains the same’ is perhaps a fitting phrase to describe the course of markets last year. Whilst the last few months have brought about some significant changes, the issues faced by UK equity investors are still remarkably similar to those at the start of 2019.
International investors still face the question of whether to allocate back into UK assets, having sat on the side lines for well over three years, watching the seemingly never-ending Brexit saga unfold. For UK investors, a key consideration will be to what degree their equity exposure leans toward more domestically-biased sectors such as financials, retail, leisure and property, compared to more internationally-focused areas, including a number of the so-called ‘mega caps’ in sectors such as pharmaceuticals and consumer goods.
As was the case 12 months ago, the UK market is still rated well below international indices and within this, it is typically the more domestic-focussed areas where valuations remain depressed. What is one of the key factors causing this aversion? Even though the UK officially left the European Union in January 2020, the risk of a no-deal Brexit is still very real. This would unsurprisingly have a negative impact on sterling and provide investors with a logical reason to avoid the UK. However, we expect that this risk will diminish and should pave the way for a re-rating of UK equities and outperformance of certain domestic sectors that have been in the doldrums for quite some time.
Along with a new government, 2020 will also witness a change in leadership at the Bank of England, with the new governor set to take up his post in March. Expectations for interest rate rises are muted; however, economic data following the result of the election is showing some tentative signs of improvement. The market is currently positioned in a ‘lower for longer’ scenario but should economic momentum improve, this would force a reappraisal of the outlook for interest rates. This would have positive ramifications for the unloved UK banking sector, which has struggled to earn higher returns amid historically low rates.
Another conundrum that UK investors will have to grapple with is the value versus growth complex. Value as a style has been out of favour for such an extended period that has led to the headlines such as ‘Is value investing dead?’. Investors will often ask ‘what is the catalyst?’ and unfortunately, predicting a reversal in trends at any point in time with certainty is virtually impossible. However, what can be said with a much higher degree of certainty is that the spread in valuations between growth and value styles is close to multi-year highs. We still live in a world where approximately $10 trillion of debt globally offers a negative yield, such that ‘bond-like’ equities continue to command a premium. From negative interest rate mortgages in Denmark, to Austrian century bonds selling for low nominal yields and Greek 10-year government bonds offering lower yields than their US equivalents, these are just some of the areas that we struggle to rationalise.
Given our contrarian stance, we typically shy away from those areas that trade with the combination of above-average multiples and margins. As was the case in the bursting of the dotcom bubble at the turn of the century, when trends eventually reverse, we don’t believe investors in the best-performing areas will be given the opportunity to rotate their portfolios casually into cheaper areas of the market. As such, we continue to be patient and maintain our bias to out-of-favour areas where valuations remain depressed, such as financials, including banks, and consumer cyclical areas, such as retail and leisure. Naturally, this will also lead to an emphasis on domestic areas of the market, but that is not to suggest that one should write off the prospects for all US dollar businesses; the starting point for us is always valuation.
So much has changed, but a lot indeed does remain the same. The UK market has been in a holding pattern for some time, but as we start a new decade, we have reasons to be optimistic. Depressed valuations with low expectations for future growth, combined with tentative signs that the fog may be clearing, provide a good starting point to be more positive in the medium to long term.