Chris Brown, CIO, 20th May 2020
Our previous updates this year have, inevitably, been focused on the virus and its impact on the global economy and markets. This time, though, we thought we would write about what we see happening closer to home in the UK. Though our portfolios remain international and diversified in nature we do have material UK investments and it is worth covering how they have done so far this year and our outlook for them.
The UK All-Share equity market is now down -20% for the year as I type (having recovered from -35% down at the March lows). This lags both US equities (-9% year to date in US dollars) and emerging markets (-18%). Is this because the UK’s handling of the crisis has been significantly different (or worse) than other countries? The short answer is no. In fact, UK equity markets have three peculiarities that make it hard to do simple return comparisons with other parts of the world. First, they have a relatively large allocation to banks and energy companies. 5 years ago, energy and finance comprised over a third of the FTSE 100 Index. Today, largely due to under-performance by these sectors, this number is closer to a quarter. Oil companies have been hit by the gradual switch to renewable energy resources and the big increase in oil and gas production by the US shale industry which has kept a lid on any price rises. Banks have, since 2008, been tightly regulated and forced to carry much higher capital levels. This along with low interest rates which typically limit bank profit margins, has affected both their absolute profit levels and their returns on equity.
Both of these industries have also now been hit hard by the virus and lockdown. Demand for oil has plummeted and there remain question marks about how long industries such as air travel will take to recover to last year’s levels. Banks are always vulnerable to an economic slowdown and will inevitably take losses on the companies that do not survive the recession. Over the weekend, Andy Haldane, the Chief Economist at the Bank of England, said the Bank was considering implementing negative interest rates in the UK for the first time. This would again hit bank profitability and banks in regions which already have negative rates (the Eurozone and Japan) have struggled as they have found it hard to pass on negative rates to their customer base. Under-performing bank and energy companies have therefore been a big part of the UK under-performance.
Secondly, one way of thinking about this lockdown and its economic effect is that it is just accelerating many changes that were already in place. One of these is of course the move from the “real” world to the virtual one. We have had many video based (Zoom) meetings with clients to replace the face to face meetings we would normally have had for example. Many of the companies that drive this technology are US based and are listed on the US S&P 500 and Nasdaq markets. They also benefit from strong network effects. The more people use an application like Zoom (or Netflix), the more people hear of it and use it themselves. This can make it very hard for new entrants once a dominant player is established. The tech giants have continued to grow and dominate their respective markets. The issue for the UK is that many of these dominant players are US companies. Since the lockdown started, these kinds of companies have, understandably, performed well. A large part of the out-performance of the US markets (and of course year-to-date) is because of the continued rise of these sorts of companies.
Finally, the spectre of Brexit negotiations once again looms over the end of the year. One of the (small) silver linings of the virus for us is that it has driven Brexit based news off the front pages. However, this does not mean that the journey towards our December deadline with the EU has been put on hold. And there are reasons to think a bad (economic) outcome is more likely now than it was at the start of the year. First, the risk of a no deal triggering a recession is clearly different. We are already in the worst recession since at least the 1930s and extensive government support programmes have been put in place. The political cost of playing tough with the EU is reduced and the virus and lockdown might be a useful scapegoat for any economic costs that arise from Brexit. Secondly, European governments are rightly focussed on the support packages needed to keep their own economies afloat (and they agreed a €500bn rescue fund at the weekend to this effect). Their willingness to spend time and economic capital thrashing detailed trade issues with the UK at the end of the year is much less than it otherwise would have been. Finally, remember the UK government won a handsome majority in December. Playing tough with the EU remains good politics. The chances that this negotiating stance drives us into a no deal outcome are on the rise.
What does all this mean for our positioning for client portfolios? We have written before that our focus remains on capturing the upside when and if we emerge out of this crisis and riding out the volatility in between. Oil companies and banks should be both be big beneficiaries when the worst is over and we (eventually) see a recovery in the economy, travel resumes and the risk of negative rates subsides. Indeed, the large cap FTSE 100 index is now up 20% from its March lows on hopes for exactly this kind of recovery. We therefore think it is right to take a longer term view here, remain patient and wait for the recovery.
For the medium sized company FTSE 250 index, however, the decision is more difficult. Medium sized UK companies are more vulnerable to Brexit disruptions and benefit less from the cushion of weaker sterling as (unlike HSBC or Shell say) more of their earnings come directly from the UK. Having added to this position in September last year (and benefited from a strong Brexit relief rally into year-end) we are now likely to reduce our exposure. When and if the impact of the virus starts to reduce, there is a risk of more bad news coming to UK plc from the Brexit process. We are currently looking at alternative equity market exposure that will give us upside when the economic cycle turns up again but which does not have the Brexit risk overlay. This change will probably go through in the second half of this month. Right now, our timing on this looks to be attractive with the FTSE 250 Index 3% ahead of the FTSE 100 for the quarter as I write.
As ever, if you want to discuss any of this in more detail please get in touch. For now this will have to be a call (or a Zoom!) but we look forward to the day when face to face updates can happen once again.