Every so often something unexpected, often referred to as a Black Swan event, comes along to disrupt conventional thinking. For investors in UK equities, the EU referendum result was one such event.
With the majority of UK equities priced for a ‘Remain’ vote, the decision to leave the EU resulted in sharp falls in the FTSE 250 index’s domestic cyclical stocks, in particular UK housebuilders, challenger banks, property companies and selected retailers. Many of these stocks had already underperformed US dollar earners in the run-up to the referendum. While some domestic cyclicals have since rallied, they continue to trade materially below the levels of 23 June, with our sensitivity analysis suggesting some stocks priced for a severe recession.
Do we believe there will be a slowdown in the UK economy? Possibly. Do we believe there will be a full-blown recession? Definitely not.
The key to it all, of course, is what happens to consumer confidence and, in this respect, the next 2-3 months will be critical. While I fully expect consumption to slow, it’s unlikely to grind to a halt. Sustained wage inflation, helped by the recently introduced national living wage, and modestly positive job creation, will be two highly supportive conditions for the UK consumer. Continued credit availability will also be essential for not constraining the consumer’s ability to spend and, thus far, initial signs from UK banks over willingness to lend are favourable.
More problematic is business investment, the most volatile component in the economic growth equation and, let’s make no mistake, economic growth is an essential component of medium-sized company share price returns. In 2009, a year which turned out to rival the worst recession since the 1930s, business investment declined by around 15% in nominal terms, an outcome exaggerated by bank lending drying up altogether. While we are highly unlikely to see history repeating itself, it’s possible we could see a 10% fall in business spending, equivalent to a 1% fall in GDP.
But let’s not forget the positives. The collapse in sterling, particularly against the US dollar, should give a significant boost to exporters, adding, we believe, as much as 0.5% to GDP. Somewhat surprisingly perhaps, the FTSE 250 ex-ITs index generates as much as 50% of its turnover from overseas earners. As is to be expected, in these instances, their share prices have actually risen following the result.
Of the remaining 50% of sales derived from the UK economy, we estimate 20% of this 50% comprises ‘structural growth’ opportunities (firms such as Just Eat and Domino’s Pizza which benefit from consumers juggling time requirements, and hence ordering takeaways). The remaining 30% comprises UK domestic cyclicals – those aforementioned sectors such as housebuilders and challenger banks – which, wrongly to my mind, are pricing in a severe recession. For this reason, I have used share price weakness to add to my holdings in Taylor Wimpey, and challenger banks, Shawbrook and OneSavings Bank.
In today’s environment where economic growth is at a distinct premium, it is important to keep a sense of perspective. Against this background, I see no reason to change the overall positioning in the portfolio. I continue to maintain a clear focus on structural growth stocks, as well as companies with strong cash generative qualities and which, therefore, have the ability to deliver premium yields relative to the market. Hence our positions in housebuilders and selected retailers, such as Card Factory and Pets At Home.
I stated before the referendum that the fund wasn’t overtly overweight stocks that would have benefited from a ‘Remain’ outcome. My position appears to have been somewhat vindicated. While the fund has underperformed since the referendum result, the underperformance has been relatively modest. If I’m proved right on my more sanguine view of the economy then these stocks should rally over the medium to long term. While only time will tell as to how economic conditions pan out, I continue to expect good price performance returns from the fund’s core holdings in Paysafe, Ascential, SuperGroup, boohoo.com, Micro Focus and Just Eat to drive performance.
As things stand, the FTSE 250-ex IT index is trading at around 14.5x forward earnings, compared to the larger company FTSE 100 index which trades on the equivalent of 16x earnings. The last time a discount of around 10% opened up between the FTSE 100 and FTSE 250 indices was in 2008, a very different type of macroeconomic environment from that which, I believe, exists today.