THE FOLLOWING ARTICLE WAS WRITTEN AHEAD OF THE UK GENERAL ELECTION HELD ON 12TH DECEMBER 2019. TO READ DAN’S THOUGHTS ON THE IMPLICATIONS OF THE RESULT FOR THE UK SMALL AND MID CAP MARKETS, CLICK HERE.
Some three and a half years on from the UK’s historic referendum on its EU membership, are the thick clouds that have long shrouded the UK economic and financial market scene finally showing signs of clearing?
Having moved definitively underweight UK domestic cyclicals post the June 2016 Brexit referendum, we have, over the course of 2019, progressively introduced more balance to our portfolios. We have selectively dialled down exposure to more expensive structural growth stocks and introduced holdings in well run domestic cyclicals on low starting valuations that we think can benefit in share price terms from emerging political clarity in the UK. Brexit resolution should enable uncertainty discounts for domestic cyclicals to unwind and should give rise to a further appreciation in sterling, which should in turn provide earnings tailwinds for import-orientated, domestically exposed stocks.
Against this backdrop, the UK small- and mid-cap markets look well placed too. The Numis UK Smaller Companies Index (excluding Investment Trusts) is trading at around 11.5x forward price/earnings (P/E) – a ratio for valuing a company that measures its current share price relative to its per-share earnings – below its historic average, while mid caps are trading in line with theirs (Peel Hunt as at 01/11/19). And as the general election approaches, our small cap portfolios are now around 60% exposed to those companies whose earnings derive in the main from the UK, and our mid cap funds around 50% – this positioning should allow us to benefit as and when a degree of political certainty arrives.
For the many, will it be a ‘phew’?
At the time of writing, a Conservative majority in the December election seems increasingly probable and, if that is indeed the outcome, we can expect Boris Johnson’s October deal to pass in the New Year. On the basis that this would represent greater clarity than the current impasse, we would expect UK mid and small cap indices to react favourably. Any such rally could be sustained should substantive trade negotiations point to a smooth transition to a new relationship with the EU and the wider world.
The other potential outcome is a hung parliament and, should that happen, the likelihood of a second referendum would jump significantly. Such a vote would likely comprise ‘deal’ versus ‘remain’ and we would expect either outcome to be well received by markets, as either result would imply – again – greater clarity than we currently have.
Riding the storm
Look beyond the negative headlines and the UK economy is in decent underlying shape. Although the current rate of GDP growth at 1-1.5% is lacklustre, the employment picture in the UK is exceptionally benign and government finances are such that there is latitude for spending taps to be turned back on after years of austerity. Net trade and business investment remain in the doldrums but these stem from Brexit uncertainty, in our view, and should pass.
In the context of the global scene, the UK is by no means an underperforming outlier. And looking ahead the global picture should improve, too. The pressure of the electoral cycle on should, logically, encourage US President Donald Trump to pursue a more conventional and consistent approach to trade and foreign policy. Meanwhile, with signs that global PMIs are stabilising, inventories recovering and that business investment is on the up, there is decent cause to believe that UK listed, internationally-facing companies can benefit from these tailwinds.
An ideal launchpad
Against this backdrop, our portfolios are deliberately largely neutral relative to their indices in terms of exposure to structural growth, international cyclical and domestic cyclical companies. This provides us with a launchpad from which to express more meaningful thematic tilts as greater political clarity begins to crystallise.
While earnings growth for our portfolios is lower than has been the case in recent years (consensus-implied earnings growth for our UK Smaller Companies Fund, for example, is around 11% for 2020), the prospective P/E multiple is around 14 times and represents a smaller premium to the market than has been evident for some time (MGI as at 04/10/19). In our view, portfolio returns should benefit from the remaining ‘structural growers’ in our portfolios delivering superior growth while sustaining current multiples, while our cheaper cyclicals should be capable of rerating.
Above all, stock selection will remain absolutely key. It has been logical and prudent to introduce greater thematic balance into portfolios over the course of 2019 and we believe they are primed to take advantage of political certainty when it comes.