UK equities
09 Mar 2018 | By Richard Buxton

Embrace the new normal

Spring is in the air. Wakened from their cosy lethargy of the long winter months, Mother Nature’s ‘green shoots’ are beginning to appear.

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Stock market corrections are a healthy part of everyday investing. Embrace them, says Richard Buxton, head of UK equities and manager, Old Mutual UK Alpha Fund.

Spring is in the air. Wakened from their cosy lethargy of the long winter months, Mother Nature’s ‘green shoots’ are beginning to appear. Evenings are lighter, and the sun is just beginning to tiptoe out from behind the clouds. Change is most definitely afoot.

A change of direction has also dominated global stock markets of late.

Barely weeks into the new year and investors have experienced their first proper equity correction for some time. Having been cocooned in an unnatural environment of ever rising markets and low volatility, a period in which the US S&P 500 index, last year, registered not a single ‘down’ month, investors have tasted a morsel of the new normal. Something akin to the good old days of investing before markets were distorted by the continuous drip, drip, drip of easy money and no one was overly familiar with the, ‘it’s going up because it’s going up’ mentality.

Investors, it seemed, started 2018 in too euphoric a mood, triggering talk of a ‘melt-up.’ The term, we are reliably informed, is used to describe markets that experience a sharp rise in valuations due to a veritable stampede of investors anxious not to miss out on a rising trend.

Fear is good

Mercifully the melt-up failed to materialise. But the hope now must surely be that the correction we experienced is not just a ‘one-week wonder.’ A degree of fear, inevitably translating into price fluctuations, is healthy, giving active investors the opportunity to pick up bargains, while affording us the chance to trim top heavy positions whenever the occasion arises.

Today, despite the pull-back, underlying fundamentals remain supportive, with little evidence that recession is just around the corner. The re-emergence of a more normal upwards-sloping yield curve is testament to that. Whilst in the UK, inflation, caused by sterling weakness, has peaked and is likely to fall this year, in the US, inflation is on a gently rising path. But it is by no means accelerating too quickly and the rate of technological change continues to cap retail price inflation, even if we are now seeing some improvement in wages. 

But without a doubt, the latest reporting season in the US has revealed that profits, and industrial profits in particular, are strong. For the first time in many years, we are seeing the beginnings of a return to pricing power. While things appear fine for now, pressures are beginning to build.

The inflation genie will likely return… but in an orderly fashion

Tomorrow, or more specifically over the course of 2018, inflation will start to pick up, and as long as it doesn’t surge ahead, that is how it should be. Inflationary forces are already at play. President Donald Trump’s tax cuts have meant that the scale of bond issuance, driving down prices and driving up yields, will have to rise if the US Treasury department is to keep its coffers from emptying too quickly. That, and the US Federal Reserve starting to unwind its balance sheet, putting an end to the era of ultra-cheap money, should combine to push yields on the US 10-year bond over the all-important 3% level.

The key question, not just for UK investors, but global investors generally, is to what extent will this upset the equity applecart? Personally, I think the market can absorb the rise but the key word in all of this must surely be gradual. Bond yields should rise; gradually. Monetary stimulus should be reduced; gradually. Interest rates should rise; gradually.

Implications for the UK equity investor

Against a background of gently rising interest rates, a change in stock market leadership should become apparent. The rise and rise of the so-called ‘bond proxies’, companies with above-average yields and solid, dependable earnings, looks to have come to an end… finally. Judging from their share prices and pedestrian sales growth, confectioner, Nestlé, does not look quite so sweet, fast-moving consumer goods giant, Unilever, not quite so fast moving.

By contrast, UK banks, such as Barclays and Lloyds, should be the clear beneficiaries of a tightening interest rate cycle. Leaner, better capitalised, and the recipients of severely improved cashflow, these companies must surely be rewarding shareholders with higher dividend pay-outs sooner rather than later? Financials aside, oil majors, BP and Shell, are able to maintain their level of dividend payments, even in the event that the oil price falls to US$50 a barrel. In the mining sector, Glencore and Rio Tinto are in the investment sweet spot, benefiting from the pick-up in natural resource prices and reaping the benefits of vastly improved cashflow.

The ability to make money this year may not be as easy as hitherto. But the opportunities for the active manager appear, at long last, to be opening up. So, three cheers for the return of volatility and three cheers for a return to more ordinary conditions.

I, for one, welcome the onset of the new normal.

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