19th July 2024
We are often asked for our views on upcoming macro or political events and how we are positioning our funds accordingly. The answer is always that we don’t have any edge in forecasting such events so don’t try, but crucially even if we did get the prediction right, making the correct consequential investment call is often even harder. For example, at the start of the year, the market was pricing in six interest rate cuts by the Federal Reserve in the US. If you had correctly guessed there would be none by this point in the year, you might have reflected that view by shorting the high growth Nasdaq index. This would have cost you dearly with the index up over 20% so far!
This year has been well flagged as a huge election year with more than half the world’s population going to the polls. This has naturally created plenty of news headlines and has given lots for investors to consider, but has it really made much of an impact on financial markets? While we have seen some big moves in the immediate aftermath of the elections in France, South Africa, Mexico and India, their respective stock, bond and currency markets quickly settled down once the certainty of the result allowed some rational analysis. India’s election is another example of getting the prediction right but the investment call wrong. If you had forecast that India’s Prime Minister Modi would fail to secure an outright majority, and therefore find it harder to continue to push through the hugely successful reforms, you might choose to sell your Indian equity exposure. That would have been the correct call for 24 hours when the market sharply fell on the news, but the Sensex Index is up 12% since then.
Looking at our own country, how have the UK markets responded to Labour’s landslide victory in this month’s general election? As everyone already knew that Labour were odds on favourites to win with a large majority, it was no surprise that markets were relatively calm the next day. Any ripples would only have occurred if a result other than a Labour majority had transpired. However, the removal of that uncertainty regardless of how likely the result, has definitely improved sentiment towards UK assets – not difficult considering sentiment was rock bottom after years of political shambles! Without going into the whole set of policies, a commitment to growing the UK economy, but without the reckless borrowing suggested by Truss/Kwarteng, should benefit UK domestic orientated companies which tend to reside in the small and mid cap indices. We have been heavily invested in UK smaller companies funds for at least 18 months, a decision not predicated on the outcome of a future election, but on the valuation case where single digit multiples and high dividend yields were commonplace and indicated a huge margin of safety even if a recession occurred or further political turmoil ensued. But it wasn’t just small caps that were outstanding value a year ago, Artemis UK Select’s mostly large cap portfolio was trading on an 8.7x PE as recently as February this year, and is still just 9.3x despite returning 14% this year. For context, the UK market as a whole trades on 11.5x forward earnings today (10 year average 13.1x), which compares to the US market’s 21.4x (10 year average 17.9x). (Source JPM Guide to Markets.)
These depressed valuations do not hang around for long, as trade buyers, private equity, or the companies themselves will buy the shares. The amount of company buybacks is significant with around half the UK index buying back their own shares at a rate of around £1bn per week. This is helping to offset the relentless selling by pension funds and national wealth managers, with the current running total at £22bn redeemed from IA UK equity funds over the past 3 years – we understand that is a run of 37 consecutive months of outflows! A quick aside linked to our recent Crescendo called “Let’s be ‘aving you!”, where we remarked that some investors prefer to wait for the turnaround to happen before getting involved – Aberforth UK Small Companies Fund is now up 35% since its low in October. Where are those investors happy to miss the initial bounce?
Today, PE ratios are still below long term averages, balance sheets are strong, dividend yields are high, company share buybacks are rife, inflation seems to be under control, interest rates have probably peaked, the economy seems on a steady footing and we have a settled government now the election is out the way. The missing ingredient is the inflows to the sector which we believe is mostly caused by the low weight of the UK equity market in the global indices tracked by so many passive investors. At just 3.7%, the entire UK equity market is a smaller weight than either Nvidia, Apple or Microsoft, each representing more than 4% individually in the MSCI World Index. Further, the UK is the only country in the G7 whose pension funds are underweight their domestic equity markets – all the rest are materially overweight relative to the weighting of each region in the MSCI World index. Given the significant tax breaks enjoyed by pension funds, it wouldn’t be a surprise if Labour is aggressive in going after this and mandating more investment in UK companies from pension funds. It feels as though inflows are the final piece of the jigsaw for a rerating to occur.
Unless you are very good or very lucky at market timing, being early in investments is crucial both in terms of buying and selling. It can be incredibly uncomfortable to be owning more UK small caps than US tech stocks, but while we have missed the end of the US equity bull market, we won’t be there when it has its inevitable setback, and at least we captured all the small cap recovery.
There is never one reason why a stock market rises or falls so an election on its own is not a reason to panic or get too excited. Hence our reluctance to offer opinions on such events. So please don’t ask us our views on the big one in November!
Daniel Lockyer – Senior Fund Manager
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