UK equities
28 Jun 2016 | By Richard Buxton

Old Mutual UK Alpha Fund: Post-eu referendum commentary

Not the expected outcome! Weeks and months of uncertainty on who forms the new government leadership, whether we have a general election and most of all on the negotiations on what form of new relationship with Europe is created cannot be helpful for markets, which ‘hate uncertainty.’

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Not the expected outcome! Weeks and months of uncertainty on who forms the new government leadership, whether we have a general election and most of all on the negotiations on what form of new relationship with Europe is created cannot be helpful for markets, which ‘hate uncertainty.’

UK businesses will defer capital expenditure, hiring and may well enter cost-cutting programmes.  Housing transactions will fall, especially in London, and house prices may weaken.  Consumer confidence is likely to erode, so GDP growth grinds downwards to feel flat or stagnant by year-end.

The Bank of England will monitor new mortgage approvals, housing transactions, the labour market and survey data.  They may cut interest rates, but we suspect they know this will be of little consequence.  The onus for a policy response may lie with the government to cut stamp duty on housing transactions or cut taxes on petrol, for example, to provide some stimulus.

This, though would exacerbate the budget deficit’s reluctance to fall as fast as anticipated and may indeed see the deficit rise.  With the UK’s AAA credit rating gone, notwithstanding the steep decline in sterling already seen, the pound could weaken further.

Much will depend on what happens in Europe.  European bank shares have fallen every bit as much as those of UK banks and, unlike UK banks which have raised sufficient capital, there remain undercapitalised banks in Europe.  The markets may push prices into a systemic risk phase, forcing politicians to stand behind their banks even at the cost of government-supported capital-raising.

Equally, any hint of another EU country holding a referendum likely to result in a vote to leave means the EU leadership needs to act fast to change policies on the free movement of people or face the disintegration of the European project.

Clearly the result has come at a time when there were concerns about the pace of growth in the US and the severity of the slowdown in China.  Weaker growth in the UK or turmoil in Europe increases the risks to global activity on the downside.

If monetary policy has reached the end of the road in terms of its ability to stimulate, the baton may have to shift to fiscal stimulus globally, along the ‘helicopter money’ lines.  It is unlikely this would occur until a new president is installed in the White House, over six months hence.

So considerable uncertainty and inevitable volatility in equity markets.  Expect more days of extreme moves up and down, swings of sentiment between opportunity and fear.

CHANGES TO THE PORTFOLIO IN THE LIGHT OF THE RESULT

As ever, the market moves swiftly.  Falls have been seen in the most exposed areas of the market to the consumer and financial markets – retailers, housebuilders, travel & leisure, banks, life assurers and asset managers.

The falls in many cases have priced in an immediate fall in their levels of profitability to levels associated with a very significant recession.  Lloyds Bank, for example, fell 30% in two days, which discounts not only lost future profits from higher interest rates but also a pick-up in bad debt write-offs on its mortgage book to levels which would require severe falls in house prices – and they have been prudently ceding market share and focusing on safer borrowers.

Taylor Wimpey fell over 40%, which again could be justified only in an extreme downturn in both house prices and volumes.  Crucially, their balance sheet (like the banks) is strong now unlike in 2008.  There is no balance sheet risk.  So we have held on to Taylor Wimpey and our UK banks – Lloyds, Barclays and HSBC.

We have trimmed our exposure to the life assurers, simply as we have a large exposure here, reducing Aviva a little and Legal & General slightly more.  We have been price sensitive and not participated in extreme falls.  Short term, their solvency positions are completely sound.  But the headwinds from yet lower bond yields (UK 10-year yields falling below 1%) to being able to invest to generate income over time to meet liabilities have increased.  So prudently we have reduced the size of the sector exposure.  We still hold St James’s Place and Prudential and may over time add to these stocks as the least affected by this issue.

We have held onto other consumer-related names such as Whitbread, Next, Ladbrokes & Debenhams as we do not expect a sudden collapse in consumer demand – whereas the shares did fall immediately.

Long experience of volatile markets suggests that patience is a virtue in ‘fast markets’ and strategic shifts in the portfolio balance are best conducted over time not in the heat of the moment.

OVERALL PORTFOLIO POSITIONING NOW AND RATIONALE FOR THIS POSITIONING

There is some good news.  Clearly the scale of the fall in sterling has seen many of those large-cap multinationals perform well not only relatively but in absolute terms.  We have built up exposure to companies such as Glaxosmithkline, Astrazeneca, Shire, Vodafone, Royal Dutch Shell and BP over the last year, which is helpful.  These companies remain attractive.

Not holding more traditional defensive names such as BATS, Unilever et al has proved relatively costly again, but we still feel these are expensive and valued purely relative to government bonds.

So sticking with deeply oversold and undervalued selected financials and consumer names we feel is the right course going forward.  We will look to take advantage of the inevitable swings in prices to ‘nip and tuck’ within the portfolio.

OUTLOOK FOR THE MARKET AND THE PORTFOLIO

Uncertainty will ensure volatility.  Even as clarity on the UK’s political leadership emerges, clear signals from Europe are unlikely as to our new relationship.  Evidence of the economic impact will only appear over time and it is unlikely that companies’ half-year trading statements – late July and early August – will have seen sufficient evidence to give many clues.  Expect lots of references to uncertain outlooks.

The portfolio is well placed in terms of its very large cap exposure, except its lack of traditional defensives such as tobacco and food & beverage.  Mega-caps with big international earnings will prove attractive to more investors in uncertain times.  The hit from financials has been too extreme – likewise stocks such as Taylor Wimpey – albeit more rationale valuations may take a while.

 

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