Let’s Get Cyclical, Cyclical
John Leiper – Chief Investment Officer – 18th September 2020
UK equities are deeply unloved, suffering as they do from a confluence of factors including a weak domestic economy, poor handling of the coronavirus and ongoing anxiety over Brexit. This is reflected in the relative underperformance of UK equities versus developed market peers.
With a looming October deadline, the next catalyst is Brexit and whilst near-term negotiations are likely to get worse before they get better, we continue to believe a deal will eventually be reached. If that is your base case, there is clear upside to UK equities although investors will need cast iron conviction and a strong stomach to navigate the interim volatility.
The rebound in global equities, outside the UK, has been led by the US but market breadth is thin and most of the gains have been driven by a narrow group of global technology companies whose business model is particularly suited to the coronavirus. Instead, UK equities are largely geared to value and cyclical stocks with energy, financials, industrials and materials accounting for approximately half of the FTSE 350. These sectors have fallen out of favour for a variety of reasons including dividend cuts, falling energy prices and a broader structural shift towards ‘ESG’. They also do best in a reflationary world when interest rates are rising.
Higher rates are a distant prospect, but the Fed’s announcement that it was shifting to average-inflation-targeting, felt like a key moment. As a result, Powell’s speech could be seen as the klaxon for a new phase in the global macroeconomic cycle. If this coincides with an improving economic outlook, then we could see a significant rotation within equity markets towards value/cyclical sectors, which could work to the benefit of laggards like the UK.
The return of inflation should benefit real assets such as commodities, which I see as a UK play. Commodities have performed very well recently as demonstrated by iron ore prices which allowed Rio Tinto to return $2.5 billion to shareholders, making it one of the UK’s biggest dividend payers. Whilst this is an extreme example, investors are likely too pessimistic on forecast dividend cuts, as we saw in swap markets following the subprime mortgage crisis in 2008.
Currency is another factor. The FTSE 100 is dominated by multinational companies which derive the majority of their revenue overseas, meaning when the pound is strong it acts as a headwind to profits. Setting aside near-term volatility, we think the US dollar can depreciate as much as 20% over the coming years. If sustained, a strong pound is bad news for UK equities and the economy, as it tries to establish an independent future outside the EU.
To summarise, UK equities are attractively valued and should benefit from a deal on Brexit, a rebound from overly pessimistic dividend expectations and a rotation toward cyclical/value based sectors following a noticeable improvement in the economic outlook. However, considerable uncertainty remains and at this juncture the risk to reward ratio is simply better elsewhere.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.
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The following is an abbreviated version of John Leiper’s article ‘Tide may be about to turn’ for Investment Week magazine. Follow the link and read his views on page 23.
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