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Monday, 27th March 2023 10:57 - by David Harbage
For the first couple of months on 2023, financial markets have been focused on the pace and magnitude of inflation, together with the extent to which central banks would raise interest rates to choke off economic demand and restrain higher prices. However a reminder of the 2008 global banking crisis suddenly emerged in mid-March when the Silicon Valley Bank and, more significantly, Credit Suisse bank ran into financial difficulties and required exceptional intervention by the Federal Reserve and European Central Bank.
Geo-political concerns represent the other prime focus for investors; in particular the extent to which non-democratic countries like Russia and China seek to use military means to expand their borders or influence. Investors have speculated about the Covid-induced reversal of globalisation in trade, which is set to restrain global economic activity as governments increase non-productive spend on defence.
Fears that another global financial crisis could be imminent had the effect of lowering expectations for rate hikes – both in the United States and further afield. After fifteen years of experiencing negligible near free money, the cost of servicing debt has risen dramatically: UK Bank rate began 2022 at 0.25%, ended the year at 3.5%, and is currently 4.25%. The magnitude of interest rate tightening in the US has been even more startling: in 2022 the Federal Funds rate increased from 0.08% to 4.33% (a 6,000% annual increase in expense), and is currently 4.88%. Regulators, banks and institutions have struggled to cope with the magnitude and pace of such a change in the financial landscape.
At the beginning of March the market was forecasting end 2023 overnight money rates of close to 5%, but the SVB and Credit Suisse episodes are likely to persuade for a more cautious management of monetary policy (as financial system stress will counter economic concerns surrounding higher prices). This is likely to mean that inflation is more persistent, does not fall back into target range as quickly as central bankers had wished, but could deliver a better outcome for both consumers and corporates.
US inflation data, released in mid-March, showed the Consumer Price Index (CPI) had risen by 6% over the year to the end of February – the eighth straight month of falls from its 9.1% peak last June – still some way off the Federal Reserve’s 2% target. In the UK, after four months of decline from its October ’22 peak of 11.1%, inflation surprisingly rose from 10.1% to 10.4%. The cost of food (in part caused by shortages) and labour rates have been a particular driver and an ongoing concern (as wage rises could imbed and perpetuate inflation), although there is growing evidence that the peak in industrial action may have passed.
Economists and market strategists anticipate sluggish global and domestic economic activity this year, with the Chancellor forecasting 0.3% growth in the UK’s gross domestic product (GDP) in 2023, and domestic inflation to have fallen to 2.9% by the year end. Taking a global perspective, the peak in interest rates is expected to be within view by the summer and to have occurred by the autumn of 2023. Against such a backdrop, history suggests that both fixed income, property and equity (business or company share) investments can make progress in anticipation of a more benign economic outcome next year - with global economic growth of 2% the consensual expectation.
Beyond the hard economic data, the biggest catalyst to seeing a revival in ‘animal spirits ‘amongst investors would be an end to the conflict in the Ukraine - ideally with an easing in China-Taiwan political tensions. As previously intimated by the writer, the geo-political landscape is particularly difficult to call, and it is probably too early to gauge if the recent meeting of Presidents Putin and Xi Jinping in Moscow will have the effect of restraining war-mongering or increase tensions with the Western world. We retain hope that pressure from China, whose economy is so the export-dependent, can facilitate a positive outcome to the Ukraine conflict.
In the first quarter of 2023 global stock markets have had a ‘roller coaster’ experience. Optimism at the beginning of the year, fuelled by forward-looking business surveys - indicating improving business confidence supported by the prospect of a return towards normality in economic data in 2024 – gave way to a sharp rise in volatility and interest rates in March in response to the bank failures. A reversal in the declining bond yield trend meant that the valuations of real estate and other highly geared businesses (which often feature start-up and venture capital) came under pressure.
By contrast, investors were cheered by corporate results – both from multinationals, smaller listed companies and the unquoted sector – which had featured prudent management of operational costs, post the Covid experience, and balance sheets with low indebtedness. In FTSE 100 terms, the index progressed from 7,500 at the beginning of January to reach a new all-time high of 8047 in mid-February, before retreating dramatically from 7,900 to 7,250 within a week in March, before trying to recover confidence after ‘rescues of a sort’ had eased bank run contagion fears.
Company share valuations, both businesses quoted on recognised stock markets and those unlisted, appear to discount a significant deterioration in economic conditions – notably prompted by the Covid lockdowns and Russia’s invasion of Ukraine. One means of assessing this is to compare share prices to their ‘book’ or tangible asset worth: two years ago equity valuations stood at twice their long term average, but have now fallen back to their long term trend level. Based on current earnings and asset worth, UK corporate valuations are 30% below the global mean and almost 50% cheaper than the US.
In the absence of a major geo-political crisis (such as China taking military action to control Taiwan) or depositors seeking to withdraw their funds from the leading banks – contagion on the scale of 2008’s global banking crisis – the current weakness in equity markets, and the UK in particular, can represent an opportunity for the investor wishing to own real assets (to produce steady income growth in particular) for the appropriate longer term.
Turbulence or volatility in financial markets appears to be accelerating, rather like the technology or the climate in the wider world. The personal investor has to remain aware of the headwinds but cannot afford to become too emotional and flit from one asset type to another in search of the ideal: superior returns with minimal risk. While it does not always repeat itself, history can probably give the best answer to what the future holds – be it politically or in terms of asset values.
Perhaps prompted by stagnant productivity, sluggish earnings and concerns surrounding Brexit, UK equities bear a neglected look - despite the US representing the largest contributor to the FTSE 100’s revenue (25%, compared to 22% that emanates from the UK). International predators will view such assets, priced in a somewhat depressed sterling, as being undervalued and London’s level of corporate action is expected to accelerate once current nervousness in financial markets ease.
The valuation of the UK’s medium sized and smaller companies, which historically have delivered superior profit growth and capital performance as compared to the FTSE 100, appears particularly low. A segment we favour, these businesses can be seen as both acquirers of struggling private family firms (based on the experience of previous economic downturns) and potential recipients of takeover bids as larger companies seek to expand.
In response to requests for further explanation of why the investment trusts mentioned in this blogger’s previous articles were selected, it might be helpful to provide a little more information. Almost without exception, the DIY investor can search online and discover more – including fund managers’ reasoning behind their current portfolio positioning and views on the outlook for their particular investment universe. As an appraisal for each of the trusts would merit a separate, rather lengthy piece, on this occasion a review will be limited to two UK equity-investing trusts: Henderson Opportunities (HOT) and Lowland (LWI). For what it is worth, and without recommendation, here are the factors that prompt support for (and in some cases, ownership of) these actively managed investment vehicles:
James Henderson and Laura Foll of Janus Henderson Investors manage the UK Equity multi-cap investing trusts Henderson Opportunities and Lowland. While these trusts share the same benchmark (the FTSE All-Share index, representing all London listed companies with a full listing), pay quarterly dividends and charge management fees of circa 0.5%-0.55%, there are significant differences in the investment objective. Henderson Opportunities, the smaller of the two – having a market worth of £80m – aims to deliver capital growth, and has tended to be biased towards smaller (including AIM listed) companies, with FTSE 100 constituents amounting to approximately 20% of its portfolio. Currently HOT shares appear attractively priced at a 9% discount to the underlying worth of its assets.
Notwithstanding the absence of income in the objective, HOT has increased its dividend pay-out for each of the past 12 years and the shares currently yield 3.5%. Well diversified, the largest ten portfolio holdings on 1 March accounted for 26% of its portfolio and featured FTSE 100 miners and banks: Anglo American (AAL), Barclays (BARC), NatWest Group (NWG), Rio Tinto (RIO) and Standard Chartered (STAN), as well as lesser known mobile payment group Boku (BOKU), digital media consultant Next Fifteen (NFC), North Sea oil & gas operator Serica Energy (SQZ), the UK’s fourth largest garage owner Vertu Motors (VERTU) and Zoo Digital (ZOO) a media content & services business. The fund managers seek diversification by endeavouring to identify six different classifications: early stage companies, small and medium sized compounders, fast growing smaller companies, large companies, natural resources and companies in recovery. An incentive to outperform is provided via a performance fee (capped at 1.5% of asset worth per annum).
By contrast, the £330m market capitalised Lowland trust aims to deliver growth in both capital and income, its portfolio has had a 50% FTSE 100 and 50% smaller company mix in producing an income yield of 5%. The track record of growing the dividend is impressive: over the past thirty years, this income stream has risen by a compound annual growth rate of 6.8%. As one might expect, some of the higher pay-out multinationals contribute including oil & gas, banks, life insurers and utilities feature in its portfolio. The latest inspection of LWI’s top ten positions showed Shell (SHEL), BP (BP.), HSBC (HSBA), Anglo American (AAL), Phoenix Group (PHNX), Standard Chartered (STAN), National Grid (NG.), GlaxoSmithkline (GSK) and NatWest Group (NWG), plus the smaller K3 Capital Group (KBT) which provides professional services to businesses.
LWI has a strong focus on valuation – trying to buy assets which offer growth in its business, but at the right price – in its stock selection. As with almost all fund managers, meeting management and employees (not just board directors) is critical to understanding the risks surrounding their business model, decision making and the various aspects of ESG. The shares’ currently trade on a 7% discount to its net asset worth (NAV) and appear undervalued given that they were priced at par six months ago and at a small premium to NAV a year ago.
Given that the fund managers can invest into either larger or smaller companies, they have the opportunity to exercise their skill in being able to position their portfolio where they deem most favourable. Of course, smaller companies (especially Alternative Investment Market listed firms) may be quite illiquid and difficult to trade, which might limit the managers’ ability to re-position as rapidly as they might wish. The larger companies tend to offer exposure to more mature, higher cash generative industries and defensive business activities; smaller companies tend to be faster growing – in revenue, profits and dividends – in higher growth industries, but can possess leadership positions within smaller niche areas. The fund managers appear confident that the UK equity market is undervalued, and its smaller companies in particular – something reflected in the Lowland trust’s 12% financial gearing and Henderson Opportunities’ 14% (essentially to own more of the assets whose returns are expected to exceed the cost of such borrowings).
Commentary on other trusts, across other areas of investment – by asset class and strategy – will follow in future blogs.
The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.