UK equities

Read this article to understand:

• The impact of the government’s energy price cap
• The market fallout from the government’s mini budget
• Potential opportunities and sectors to avoid

Liz Truss became the UK’s new prime minister at an historic moment. Just two days after taking office on September 6, the country entered a period of mourning following the death of Queen Elizabeth II.

When parliament resumed, Truss and chancellor Kwasi Kwarteng prioritised measures to deal with an escalating cost-of-living crisis, driven by soaring energy prices following Russia’s invasion of Ukraine. Energy bills for UK households and companies will be capped for two years to October 2024, a move that will try to hold down inflation while putting additional strain on public finances.

On top of the unfunded package to hold down energy bills, the chancellor announced a so called ‘mini budget’, including £45 billion of proposed tax reductions. A lack of detail on how the cuts would be paid for spooked markets, causing a jump in yields on UK government bonds, an intervention from the Bank of England, and eventually a reversal on the policy to cut tax for the highest earners.

Despite the government’s intervention, energy costs remain high, while some companies are also grappling with a hit to earnings as consumers tighten their belts. Those with pricing power are proving more resilient.

With share prices depressed and sterling on the decline against the euro and dollar, some UK firms have become takeover targets. In August, Canadian tech company OpenText bought British rival Micro Focus for £5.1 billion;¹ in September, French industrial conglomerate Schneider Electric agreed a £9.5 billion buyout of UK-based software developer Aveva.²

In this Q&A, Charlotte Meyrick (CM), manager of the Aviva Investors UK Listed Small and Mid-Cap strategy, and Trevor Green (TG), Head of UK Equities, give their take on a turbulent period.

Liz Truss has announced an energy price cap, while also signalling policies to boost long-term growth. How will the market respond?

TG: US economist Thomas Sowell said, “There are no solutions, only choices”. That really sums up what’s going on in the UK.

Take the energy price cap. This is good news, in our view, even if the UK was late to the party compared with its European peers. The country was going into the abyss without it. The bond market is looking at how the government is going to pay for the policy down the road, but that’s not really a concern for investors in UK equities right now; we needed intervention.

There are many examples, especially on the consumer side, where things are tough, and companies are facing a double whammy. Top-line revenues are slowing, and costs are rising - not just for energy, but every sort of material. That is affecting earnings forecasts quite materially.

On the broader point, one of the disappointments about the UK since the Brexit vote is that the economy has been running below trend growth; this is one of the reasons why global investors have not been inspired to invest. Truss has prioritised growth, but based on recent history, the jury is out on the UK’s ability to deliver.

How have conditions changed since we last spoke in June?³

CM: Markets have been incredibly sensitive to rate hikes and inflation expectations. We had an early summer rally driven by optimism we’d surpassed peak US inflation and a temporary softening in rate hike expectations. This proved short-lived as global inflation pressures heightened thereafter, with European natural gas prices rising a further 25.7 per cent in August amid persistent concerns about a Russian gas cut-off.

It’s only with the UK government’s announcement of the Energy Price Guarantee (EPG) in early September that we can say the peak for UK headline CPI should be lower and come sooner than would otherwise have been the case. In late September, markets and sterling came under significant pressure as they digested the government’s mini budget, both in terms of the political agenda and a fiscal package seemingly at odds with the monetary policy strategy employed by the Bank of England.

The market is now looking to the chancellor’s promised fiscal plan on October 31 to understand more about how this stimulus will be funded and the repercussions for the BOE’s monetary response. Expectations of a more restrictive stance led to historic upward moves in gilt yields and emergency BoE intervention to buy debt to stabilise markets.

In challenging times, we’d expect to see an investor bias towards larger stocks. But the differential between the FTSE 100 versus the FTSE 250 in 2022 is dramatic (see Figure 1). What do you put this down to, and is it justified?

TG: The driving factor for the first six months of the year was the difference in the composition of the FTSE 100 Index, with mining, oil and pharmaceuticals taking a larger share. These sectors have performed well and don’t have much of a presence in the FTSE 250.

Companies in the FTSE 100 also have more overseas earnings, but it’s debatable whether this was a factor in the index’s outperformance, as we have seen growth slowdowns around the globe.

CM: As UK recession fears have grown over the summer and sterling has weakened, this has become an equally important driver of mid-cap and domestic stocks’ underperformance. We need to be nearer the bottom on economic indicators for the momentum to switch back in favour of being overweight mid-caps and for the FTSE 250 to outperform.

Figure 1: YTD performance of the FTSE 100 versus FTSE 250 (per cent)

Source: Eikon, Aviva Investors. Data as of October 7, 2022

What have you seen in terms of inflation impact on UK companies?

TG: The market was right in its assessment that smaller retail companies without pricing power or a proactive management would face the greatest impact.

Larger companies have performed better. Take consumer goods giant Unilever, which has a track record of dealing with economic challenges and resilient pricing power. The company has been able to raise prices without a decline in sales. 

Other companies have sensibly managed the impact through hedging their future gas consumption, locking in lower prices. For example, packaging company DS Smith has 90 per cent of its gas consumption hedged for 2023 and 80 per cent for 2024. A lot of large public companies are doing this.

Which sectors are showing resilience?

CM: Resilient sectors include tech and media, as they are predominantly only experiencing inflationary pressures on their payroll and IT systems as raw materials and energy aren’t big components of their cost base.

You would think the whole consumer discretionary sector would be struggling, but it’s a mixed picture. Take a business like Howdens, which has long been the market leader in selling kitchens to the trade community and whose competitive moat widened during the pandemic. It has put through double-digit price inflation over the past 12 months and maintained volume growth.

Similarly, WHSmith, which has outlets in train stations and airports, has benefitted from travel rebounding this year after the lockdowns of 2020 and 2021. The company has seen increased sales due to the economy being open and people wanting to spend their money on the things they enjoy, given they haven’t been able to do that for so long.

Luxury has also held up well with Burberry and Watches of Switzerland speaking to robust demand persisting in EU and US.

Where might the opportunities lie over the longer term?

TG: We want to invest in companies with structural growth opportunities irrespective of the macroeconomic picture, recurring revenues and thus predictable earnings. One example is Sage, which provides payroll and HR software, and already has part of its revenue lined up because of its subscription model. And companies with pricing power, like pest control firm Rentokil: if people need Rentokil products, they are going to have to buy them regardless of the economic situation.

More generally, we are looking for better-quality companies that have been investing in productivity, innovation and online offerings for years, rather than suddenly trying to do these things in a downturn. That makes quite a difference. Better-run companies look through the cycle and into the future.

Elsewhere, the Biden administration’s planned investment in US infrastructure will be a source of structural growth for UK construction companies. Infrastructure spending should go ahead irrespective of what's going on in the US economy and housing market.

What kind of companies are you looking to avoid and where do you see biggest downside risks if the economy goes into recession?

TG: In the first year of the pandemic, we had an open window for companies to come and raise equity. That meant many companies’ balance sheets were in good health coming into this year.

By contrast, companies early in their lifecycle or highly sensitive to a slowing economy look to be in more trouble. We are already seeing examples of companies having to raise equity at prohibitive discounts.

CM: There are situations where we own stocks whose earnings have come under pressure, or we suspect will come under pressure in the coming months. But in many instances these stocks have already de-rated substantially, factoring in the negative earnings revisions to come.

One doesn’t want to capitulate on these stocks today when expectations are low and the uncertainty on forward earnings is already in the price. Equally, one wants to have confidence the business model can withstand the challenging macro backdrop and maintain the competitive moat. One can ride out short-term negative sentiment and earnings downgrades if there is already valuation support and you’re taking a long-term view.

We have seen some large takeover deals in the UK recently, such as Schneider Electric’s buyout of Aveva. Given the fall in value of sterling, are we likely to see more M&A activity?

TG:  M&A activity will remain elevated. The cost of funding is going up, but on the other hand the decline in the currency means these deals are now more affordable for overseas buyers. There is a lot of short-termism and skittishness among investors in the UK, which has hit share prices and bolsters the case for companies to do M&A deals now. The buyers invariably have a longer-term focus so see this as their opportunity.