Where does the time go? We’re already into the final quarter of 2023 – and it’s probably fair to say that most investors will not be particularly sorry to see the back of a year of financial headwinds.
UK households and corporates alike have had to get to grips not only with persistent and painful inflation (now at 6.7%, only marginally below last month’s level), but also with the Bank of England’s interest rate onslaught. September saw the first breather since December 2021, with rates held at 5.25% – but there may be more rises to come if inflation remains sticky.
Elsewhere, as well as inflation and interest rates the US has wrestled with a mini banking crisis; China’s economy has failed to kickstart after the post-Covid reopening last December; and rising oil prices are again biting globally.
These are deeply uncertain times, and UK fund managers might be forgiven for feeling that it’s high time the mood of unremitting gloom lifted and made their lives a little brighter. What are their biggest concerns looking ahead?
Interest rate damage
Interest rates and their potential for damage unsurprisingly top the agenda. For Julie-Ann Ashcroft, multi-asset portfolio manager at Fidelity, the worry is that globally, central banks’ interest rate hikes are indeed “having the desired negative impact” on economic growth.
“Companies are refinancing at higher rates and cracks are beginning to emerge in leveraged loans, private debt and commercial real estate,” Ashcroft points out. “Leading indicators point to weakness in coming quarters.”
Economic slowdown is particularly evident in Europe, with a number of profit warnings issued recently, and China too is struggling.
Nor does the UK feel remotely like a safe investment haven. For Stuart Widdowson, who manages the UK small and mid-cap focused Odyssean Investment Trust (LSE:OIT), the biggest danger facing Britain now is “monetary policy error” - the potential for excessive rate rises to cause a deep recession that would hurt even relatively resilient smaller companies.
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Continuing interest rate hikes could also further fuel the UK’s current cost of living crisis, says Rowan Stone, sustainable portfolio manager at atomos. And that in turn could renew the risk of the economy falling into “a wage-price spiral where high wage growth begets inflation, which feeds back into even higher wage growth”.
The surprise attack on Israel by Hamas is a fresh dose of geopolitical uncertainty.
Other geopolitical risks concerning investors include tensions escalating between the US and China.
Stone says: “Tariffs and quotas may be enforced between the US and China, particularly following the recent White House ban on US investment in Chinese tech sectors,” he says.
Jon Forster, manager of Impax Environmental Markets (LSE:IEM) investment trust, outlines widespread concerns about the political headwinds now facing the environmental movement: “The recent row-back on environmental policy in the UK, combined with noises on the Republican right in the US, have stoked fears of a broader reversal.”
However, he believes that despite some slippage, policy momentum remains in place, and importantly, that businesses remain committed to long-term targets such as net zero. “The portfolio impact [of political rowbacks] is negligible, as corporates appear to be pressing ahead regardless,” he adds.
Ultimately, says Wes McCoy, manager of abrdn UK Value Equity fund, economic cycles are inevitable; it’s just that this is proving a particularly extreme one. “The fear that this cycle has created is palpable, and demonstrated by a general distrust of cyclicality and any risk around liquidity,” he observes.
Reasons to be upbeat
So, where are managers seeing signs of silver linings or even breaks in these clouds of persistent gloom?
McCoy, as a committed contrarian, is very interested in the extremely low valuations currently available among the UK mid-cap sector.
He suggests taking a longer view, to the start of the next economic upturn: “Perhaps the obsession with interest rates is hiding the virtues of businesses and their models, so we think about how things could look when fears abate.”
In the meantime, outstandingly attractive valuations on good-quality businesses, and the potential for re-rating as and when sentiment improves, are providing good reason for managers to raise at least a modest smile as they look forward over the coming 12 months.
Take Baillie Gifford, an asset manager renowned for its single-minded focus on growth. It has had a pretty rough ride over the past 20 months or so in the face of the changing economic environment, as the future-facing businesses in which it invests are particularly hard hit by rapid increases in the cost of the borrowing that enables their expansion.
However, says James Budden, director of marketing, the good news is that most “have quickly adapted to a new higher interest environment with its focus on profits and positive cash flow, as opposed to building market share through cheap money”.
Budden reports that they have been able to demonstrate both pricing power and competitive edge in the face of inflation – bucking widely held expectations of growth companies’ capability to deliver in such restrictive circumstances.
“At some stage the attractive fundamentals of growth companies will be recognised by the market in share price terms,” he adds. The big question is when; meanwhile, though, opportunities abound for canny investors with a long-term perspective.
IEM’s Forster, another growth-oriented manager, sees glimmers of global macroeconomic encouragement in that respect: “Global inflation continues to moderate and markets are increasingly confident that the interest rate cycle has peaked.”
He makes the point that even if rates don’t return to pre-2022 levels, we should see a convergence between market expectations and central bank forecasts, which should help steady the ship and “pave the way for relative outperformance of growth”.
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But one of his biggest reasons to be cheerful is around valuation. “Today, IEM’s portfolio trades at around 18 times the forward price/earnings ratio. That’s back to pre-Covid levels, despite much stronger legislative support for environmental markets that will underpin long-term growth.”
Helen Steers and Jie Gong, lead managers of private equity investment trust Pantheon International (LSE:PIN), agree that global economic conditions are improving and in the meantime valuations remain alluring.
Moreover, they add: “2024 is expected to see the first rate cut in the US, which will be instrumental in rejuvenating the deal-making ‘animal spirits’ driving both US and European private equity investing and exit activities.”
At Fidelity, Ashcroft, also a global investor, points out that in the meantime there are good opportunities for multi-asset managers to find targeted equity bargains in specific markets, particularly among higher-quality sectors.
“Many emerging markets, such as India, Taiwan and Brazil, have solid growth and inflation outlooks, with attractive valuations,” she says. She also likes large-cap UK equities, which are not only very cheap but also largely internationally focused, sidestepping many of the UK’s economic headaches.
Potential catalysts to turn around UK market’s fortunes
The sheer unpopularity of UK stocks, particularly small and mid-caps, is compounded for investment trust managers by the wide discounts that have opened up as closed-ended fund investors have voted with their feet over the past two years.
However, for Stuart Widdowson, manager of Odyssean Investment Trust, the expectation is that in due course the market will gain confidence that inflation and interest rates have peaked, and that will have a make a big difference to sentiment around decimated mid-cap and smaller company stocks.
As and when it happens, he says: “The lower liquidity of smaller companies in particular means that the market recovery is likely to be a sharp and material re-rating.”
In the interim, many of those with international earnings are trading at a discount to their global peers; if they don’t see a re-rating as confidence improves, Widdowson expects to see a run of takeovers from their international counterparts in the course of 2024. Again, shareholders should be set to benefit.
The problem that faces all these commentators is that eventually the economic backdrop will improve, and with it the fortunes of the companies they are currently able to buy so cheaply. They just don’t know when the upturn will happen.
But as McCoy observes, this is when a flexible time horizon comes into its own. “If the prize is large and the company has what it takes to weather this difficult time, a laser-focused view on when things will turn becomes less important,” he concludes.
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