Why UK market will weather tariff storm, and backing the banks

Alex Wright, manager of Fidelity Special Values Ord (LSE:FSV), explains why the UK market is well positioned to weather the US storm brought about by US President Donald Trump's tariff policies.

Of late, Wright has been strategically adding exposure to UK domestic-facing businesses that are insulated from tariffs. He tells interactive investor’s Kyle Caldwell, which stocks he's been buying.

Wright also explains why he continues to be a fan of the banking sector, and why interest rate cuts, and the prospect of more to come, doesn't lessen the sector's attractions.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider Interview. I'm Kyle Caldwell, and today in the studio, I have with me Alex Wright, manager of the Fidelity Special Values investment trust. Alex, thank you for coming in today.

Alex Wright, manager of Fidelity Special Values investment trust: Thanks for having me.

Kyle Caldwell: Alex, your view is that the UK market is well positioned to weather the US market storm that's been brought about by US President Donald Trump's tariff policies. Could you explain why?

Alex Wright: Yeah, so clearly it's been very big news over the last couple of months, the tariff announcements, re-announcements, changes, etce. But I think the UK market and the economy is actually reasonably well insulated just because of the make-up of the UK economy and the market. So, we're a very service-dominated economy. We're not a big exporter. We don't have a big trade surplus with the US unlike the European Union or China.

Also, if you look at the make-up of the UK market, it doesn't have exposure to the type of companies which are badly affected by tariffs. So, complex global supply chains like you see in advanced manufacturing, advanced technology, like an Apple or a large auto-maker or a larger aerospace company. Stuff's made all over the world, shipped all over world. So, there's multiple tariff barriers and effects of that, which definitely does quite badly affect a number of the biggest companies quoted in the US, some of the big ones that are quoted in Europe and clearly some of ones that are quoted in China and Japan, but not really the UK market.

So, it's not really about UK-US trade deal, it's much more about the mak-eup of the UK economy and the make-up of the UK market that makes us reasonably well-placed in this world where there's a lot of uncertainty about those tariff levels.

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Kyle Caldwell: I understand that you've been strategically adding exposure to UK domestic-facing businesses that you think are relatively insulated from tariffs. Could you talk us through which companies you've been buying?

Alex Wright: Yeah, so if you think about UK retailers, they import a lot of goods from China and anyone that imports goods from China that isn't the US is actually benefiting from tariffs because it's very uncertain what the tariff levels will be.

But any level of tariff makes it less attractive to go to the US, and so gives you more spare capacity to go elsewhere and therefore potentially lower prices in sourcing. Also, if there's less trade, the prices of shipping things from China will also fall.

And then you've seen the pound be reasonably strong versus the dollar and the Chinese renminbi, which again makes it cheaper. If you then think about consumers' ability to buy, what that stronger pound means is that's good for inflation.

Also globally slower growth maybe means interest rates come down, so it's cheaper to borrow for consumers. And the UK consumer has a high level of savings, so there's the ability to spend because they've got that pent-up demand. So, for a little while, probably over the last six months, we've been looking for more plays on this area.

We've already had the likes of Halfords Group (LSE:HFD) and Norcros (LSE:NXR), which are in the portfolio. But two recent new additions would be DFS Furniture (LSE:DFS), the sofas business, and then Frasers Group (LSE:FRAS), which used to be called Sports Direct, which is a general retailer.

Those stocks are very attractive valuations and, I think, are benefiting from those trends which are basically reducing their prices, while at the same time the consumer has potentially got more money to spend as interest rates fall.

Kyle Caldwell: In the previous video (part one), we talked about your exposure to UK mid-caps and UK small-caps, but you also have exposure to the FTSE 100 index, the larger companies. Could you talk us through the key sectors that you invest in with that index?

Alex Wright: So, obviously over time it will change on what's attractive but in terms of where we are today in some of the big stocks and sectors, we've got quite a large weight in tobacco, which is about 7% of the fund across both Imperial Brands (LSE:IMB) and British American Tobacco (LSE:BATS) in consumer staples.

Then financials is big, overall that's about 25% of the fund across not just large-cap but mid-cap names as well and that would be both banks, insurers and other financials. Then the big areas that are large in the index that we don't have exposure to, or very low exposure to, would be things like pharmaceuticals, oil and gas, and metals and mining.

Kyle Caldwell: As you mentioned, interest rates have started to decline and they're expected to decline further, although I think it's very unlikely we're going to return to the days of interest rates being ultra-low. How, then, do you approach your UK banking exposure? Does it make the sector less attractive?

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Alex Wright: Yes, so retail banks, the likes of Lloyds Banking Group (LSE:LLOY) and NatWest Group (LSE:NWG), make a lot of their returns from the fact that people have current accounts that don't pay interest. Therefore, when interest rates are higher, they make a larger margin than they do when interest rights are low. And, clearly, ultra-low rates are a real problem because it's culturally very difficult to charge people for their current account, but there clearly are costs of running those current accounts and branch networks for the banks. So, that was the clear problem throughout the period of ultra-low interest rates.

As long as interest rates are above 1% or 2%, the banks are able to make a very good return on capital, and we always think about scenarios. So, what is this bank worth if interest rates in the future are 1%, 2%, 3%, 4%, 5%? And we think about what the risk/reward looks like. The banks look very attractive at rates over 2%, clearly they're not as attractive as they were when they were 5%, but still very interesting investments.

And then there's the UK banks, which are quite different from some other banks, particularly, say, US banks, etc. They have what they call a sort of rolling hedge. So, actually the benefits of rates going up, the banks don't just put all the money that you have in a current account on short-term deposit with the Bank of England. Actually what they do is they buy the equivalent of five-year bonds, and they do that on a sort of rolling basis. So, it's been less than five years since interest rates went up. They only really went up in 2022. So, the benefit of that is still coming through in the bank's earnings until 2027.

So, yes, interest rates are going down, but you won't actually see that in the profits of banks until at least sort of 2028 and onwards. So you've still got very good returns, very good dividends and buybacks from the banks in the meantime.

Kyle Caldwell: I next wanted to ask you about gearing. So, investment trusts have the ability to gear, or borrow to invest. What are the current gearing levels at the moment and what's your typical range?

Alex Wright: The range is quite variable. We have the ability to go up to 30% geared, but the current board limit's about 25%, and we've been as high as 20%. We've been low, basically no gearing, and we're about 7% today. I'd say that's slightly below the typical levels, and that reflects the fact that the markets have had a really quite strong run on an absolute basis. So, the trust is at an all-time high. The FTSE 100 is at an all-time high and particularly [for] some of those larger-cap stocks, we have been taking some profit recently and that's moved the net of the fund down recently.

Kyle Caldwell: What would need to happen for you to increase those gearing levels? I assume the answer may be if there's a pullback in the UK equity market, you would then look to increase gearing as a tactical decision to take advantage of that.

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Alex Wright: If you look at the fund and how it's worked over time, when was the highest-ever gearing? It was the day before we discovered the Covid vaccine because the market had fallen a lot and we'd been gradually buying more and more stocks as we got more and confident about what was happening on the ground and the value on offer. Then the gearing started to fall again as the market rallied and prices moved back to a more reasonable level.

Similarly, when markets fell in early April, we moved the gearing up from about 12% to about 14% as markets fell, and then as markets have rapidly grown back, again the fund's performed almost 20% from the bottom, and we've taken that gearing back down again. I suppose the more recent period of adding and then taking away has been much tighter than it normally would be because the market fell so quickly and then rebounded quickly.   

Kyle Caldwell: And finally, Alex, I last had you in the studio around 18 months ago, so I know that you do personally invest in Fidelity Special Values. So, instead I wanted to ask, when was the last time you bought shares in the investment trust?

Alex Wright: Certainly over time my ownership of the trust has grown. The last time I bought was last November because I saw reasonably good valuations and quite a lot of opportunity and a good discount on the trust as well, and we tend to do that. So, I wouldn't buy every year, but I do probably add on average every year, but not necessarily in every calendar year.

Kyle Caldwell: Alex, thank you for your time today.

Alex Wright: Thank you for having me.

Kyle Caldwell: So, that's it for our latest Insider Interview. I hope you've enjoyed it. Let us know what you think. You can comment, like, and for more videos in the series, do hit that subscribe button. Hopefully, I'll see you again next time.