UK Equities

Read this article to understand:

• Why the discount of UK equities to global stocks has narrowed in 2022
• The impact of higher inflation
• The main opportunities and challenges in the UK market

After years of largely uninterrupted gains, many developed equity markets have taken a battering in 2022; reeling from the removal of monetary stimulus, surging inflation, rising interest rates to combat that, and heightened geopolitical risk in the wake of the Ukraine-Russia conflict.

Despite not being immune to these factors and the country’s own softening economic outlook, UK equities have been among the few resilient performers so far in 2022, with the FTSE 100 up three cent in the first five months of the year.

To find out why and get their take on the longer-term outlook, AIQ talked to Charlotte Meyrick (CM), manager of the Aviva Investors UK Listed Small and Mid-Cap strategy, and Trevor Green (TG), head of UK equities.

At the start of 2022, many were hopeful we would see a narrowing of the UK equity discount to global stocks. How are things playing out?

CM: The UK market has outperformed in 2022 so the gap has narrowed, but to some extent for different reasons to what we expected earlier this year (see Politics, activists and ESG: The outlook for UK equities).

The UK’s outperformance is mainly due to the fallout from the Ukraine-Russia war and the composition of the stock market. Sectors that have done well since the war started – energy and materials – have a big weighting within the UK relative to other markets. Given Russia and Ukraine’s position as significant exporters of oil and agricultural commodities, the supply shock in an already tight market led to significant increases in the price of oil and other commodities, buoying the sectors’ earnings and cashflow.

At the same time, one of the reasons we expected the UK equity discount to narrow was the value composition of the UK index, given the rising rate backdrop, and this is playing out to an extent. Value as a style is still lagging the move in real yields, suggesting there could be scope for value stocks to continue to perform.

Valuations remain attractive given the scale of the earnings upgrades that have come through in this part of the market, and many value sectors continue to be seen as a good inflation/interest rates hedge. Our style agnostic approach allows us to invest in all parts of the market, giving us flexibility to position portfolios where we see the greatest mis-pricings and single stock opportunities.

TG: This year has been about getting your sector calls right: it’s not stock specific. The energy sector in particular has driven market performance, not unlike the way the tech sector drove US stock performance in recent years.

Investors have also walked away from currency. Sterling is down over nine per cent year to date versus the dollar, which should provide a tailwind for a lot of FTSE companies, but right now market participants are focused on other things. That is unusual, but as we go into the second half that could be a good buffer against inflation or a fall in revenues, especially for the big dollar earners in the index.

One sector that has surprised me is UK banks, which have outperformed US banks. Standard Chartered has been a star performer and we’ve also seen some of the consumer and mortgage-focused banks be very resilient.

The energy story this year has all been about the traditional big oil and gas companies. Are the pure-play renewable companies benefiting from a similar tailwind?

TG: It makes a huge difference whether you are an established player. Greencoat Wind is well supported because it has an established wind portfolio. That is very different to early-stage companies looking to raise capital in debt or equity, where the market is more sceptical.

The Ukraine-Russia conflict has added uncertainty and inflationary pressure. What has been the impact on UK stocks?

CM: We focus on how to position our portfolios against the inflation and geopolitical backdrop. In the Small and Mid-Cap strategy, we hold a few defence stocks, and they look to be well supported in an environment where Germany and other NATO countries are contemplating an increase in defence spending. Outside of that, real estate tends to be resilient in this type of environment as a lot of companies have rents linked to inflation, so I feel comfortable about our exposure there.

We look for businesses in supply constrained markets that can comfortably pass on price increases; housebuilders have that ability, so does the new and used car market. We also look for structural growth opportunities in sectors like healthcare and media, which are relatively immune from energy and commodities inflation as these costs are a small part of their operating expenditure.

TG: Just to add context on the inflation issue; oil price spikes through history tend to be bad for economies, but they're not always bad for equities. Equity markets have been able to look through the spikes and form constructive longer-term views on where the opportunities are.

At the same time, investors are rightly concerned about companies that are big energy users. While many will have forward contracts for their supplies, they aren’t in place for ever. Those companies will have to renegotiate those contracts and that will be a headwind for the second half of 2022 and next year especially.

We’ve also seen a marked difference in terms of performance between the FTSE 100 and FTSE 250 this year, with the FTSE 100 up around three percent in the first five months and the FTSE 250 down around 13 per cent. The war has led to risk aversion; in these situations, investors are less comfortable in smaller companies, but that will change at some point. 

What about consumer and retail? Presumably rising inflation is having a big impact.

CM: So far this year we have not seen discretionary consumer spending slow in the UK, with companies reporting fairly robust top line trends. Consumers are continuing to go on holiday, eat out and spend on entertainment. You would have thought those are the sort of activities that would get squeezed quickly if people were feeling the pinch. That points to the labour market still being strong, people are financially in a good place due to the rise in savings in the last two years, and mortgage rates are still low by historical standards.

Clearly, consumer confidence indicators tell a different story. We are yet to see the full impact of rising energy and food costs on households, which is likely to be a story for the second half and next year. But from a market perspective, a lot of companies have already derated significantly in the past 12 months. We think the extent of potential downgrades is already priced into a lot of these names, if not more than the potential downgrades we could see.

For us, it's a case of going through the consumer companies we hold and assessing how well they will hold up. We’re interested in owning sub-sectors we think will continue to show relatively resilient demand, and market leaders that will be able to accelerate market share gains from weaker peers in the event consumer spending slows.

Where do you see the best opportunities?

TG: As an investor, you can’t be emotional; you have to be patient and stay focused on the long-term trends and who you believe the winners will be. There are good opportunities, but as a long-term investor, it is about adding exposure to companies we already hold rather than shooting from the hip on new names.

At times like these, it is important to up our engagement with companies and speak to management about how they are planning to get through this period and what they are they seeing. You can’t get carried away by falling valuations; it is not the time to speculate. Share prices aren’t running away from investors, so it is fine to wait, have those conversations with companies and get the assurances you need before deciding whether to act.

We are having a fair amount of debate around China, which is a big market for many FTSE names, for example luxury goods companies. In other markets, we’ve seen a good bounce across sectors as their economies have eased COVID restrictions. China still has those in place, and that has had a knock-on effect for companies with large exposures to that market. Without second guessing Chinese policy, those restrictions will come off at some point so I am looking at opportunities in names that could see upside from that.

CM: There are opportunities in both the FTSE 250 and the FTSE 100, both of which are trading below their long-term average multiples. Our strategies have historically been and continue to be overweight mid-caps, an approach that has been a key driver of long-term performance.

We believe this under-covered asset class results in more pricing asymmetries, provides more access to structural growth, and tends to be the area of the market benefiting from M&A activity.

In our UK Listed Small and Mid-Cap strategy, I have been adding selectively in industrials, real estate and utilities, while healthcare is one area where I am interested to find new ideas. I wouldn’t say there's a core theme underlying recent ideas; it's quite stock specific in a few different sectors.