Glass half full?

There have been many reasons over recent years for investors to be ‘out of love’ with the UK; Brexit, political uncertainty, pandemic, Ukraine, Trussonomics and the perception of worse inflation & economic performance for the UK to name a handful. But, has the depressed sentiment been overdone? In this podcast the team discuss that with many of these factors firmly in the rear-view mirror, and with interest rates potentially close to their peak and UK economic growth recently being revised upwards, could the glass actually be half-full, rather than the pessimistic alternative?

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JC: Hello and welcome to A Value View from the Merchants Trust. In each podcast, Simon Gergel, Fund Manager at the Merchants Trust, offers his thoughts on developments affecting the UK market and what it means for investors. Simon, it's good to join you in the studio again.

SG: Hi Jon.

JC: Now, we're approaching the end of what can only be described as another choppy year. How do you see the market opportunity in light of all of this and the direction in which it seems we're heading, as well? 

SG: Yeah, well, it's great to be here again. That's a great question. I think it's often darkest before dawn, we've had a succession of challenges in the UK stock market over the last few years, ever since the Brexit referendum. There's been a number of reasons why foreign investors have shied away from the UK and in fact, a lot of domestic investors have pulled money away. I think that's setting up the market for good opportunities going forward because it's pushed valuations down but, just to remind you, we've had political concerns about the prospect of potentially of a Jeremy Corbyn government a few years ago; we had the Liz Trust - Kwasi Kwarteng period last year. We've also had the war in Ukraine which has clearly pushed up energy prices. So, we've had a number of shocks which have affected sentiment in the UK and across Europe, to some extent, and that's led to the market being both lowly rated but also there's incredible dispersion in the market - polarisation. So many companies are trading at really quite extreme depressed levels. Actually, I think there's reasons for optimism looking forward. Many of those challenges that we've had to deal with seem to be fading into the rear-view mirror. I suppose the most recent has been this view towards the end of last year and certainly through this year, that somehow the UK was performing worse than the rest of Europe in terms of lower economic growth and higher inflation - more sticky inflation. 

JC: Would you say that's not the case? That perhaps the figures suggest otherwise?

SG: I think, yeah, it's interesting. A lot of the growth figures have been revised up in the last few months, so that actually the UK has performed somewhat better than Germany and similar to France since the pandemic, in terms of growth. And of course, inflation, having looked high and sticky, has actually started to come down reasonably quickly now, albeit still higher than the rest of Europe. So, I think the idea that the UK is somehow different and out of line with the rest of Europe and the rest of the world is… I think that's not true anymore. The UK looks very similar to other countries and if anything, our growth numbers have been revised upwards generally rather than downwards. So, I think a lot of those reasons why people sold the UK feel like they're in the rear-view mirror now. 

JC: But it has been, it feels, quite some time, this period of depressed sentiment that you refer to. When you think that the Brexit referendum was in 2016 and those other events around largely UK politics and of course the pandemic and Ukraine have stretched on for a number of years now. So, are you convinced that maybe the worst is over? Are there reasons to be cheerful too? 

SG: I think there are, I think the glass is half full in many ways, I mean clearly interest rates are higher than they've been for quite a while. But, it's interesting to see, if you look at the last two Bank of England meetings back in September it was a very tight vote. It was 5-4 to hold rates rather than increase them, which a lot of people thought there would be another increase in September. By October the Bank of England was 6-3, so 6 people voted to hold rates and only 3 to increase them. So, we're seeing a definite shift in sentiment,  shift in feeling at the Bank of England. It feels we're much closer to peaking interest rates and of course, once interest rates start to come down that could lead to a following wind for the markets as people look to get better returns elsewhere and higher interest rates have been a potentially been a bit of drag on the market. So, I think there are reasons to see there a big opportunity, particularly given how depressed the valuations in the stock market are.

JC: And In terms of economic growth and those figures as well, as you say, we've seen revised figures. What's been driving that do you think? 

SG: Well, it's… I think economic statistics were very hard to put together during the pandemic. I mean, it was almost unprecedented; you had huge movements in growth and government spending unprecedented amounts to support the economy. So, I think to actually work out the growth numbers to any degree of accuracy was almost impossible at the time. And they've had to revise them up. I'm not an economist, but I think that's my reading of what's been going on. But when you look through all of that, the UK economy has been sort of bumbling along at - you know, very modest levels of real growth, but of course in nominal terms with inflation quite high that's actually quite a big level of nominal growth. And don't forget if you're invested in companies, in equities, they are nominal animals if you like. Companies can push up prices with inflation, so companies can grow their top line often with inflation. So, in nominal terms, companies' revenues are actually growing quite a bit, even if in real terms the economy is pretty flat. 

JC: So, what about some of those companies that you're looking at, that you're considering, Simon? Which sectors are you most attracted to at the moment?

SG: Well, I think there's two or three areas we've got quite a lot of investment. So, one is the whole building and construction area which is quite diversified. Another one’s insurance. But if we talk about building materials and construction, we've got exposure across a number of parts of that market. Everything from house builders in the UK, to infrastructure materials in North America, to a company that is the market leading company making door and window components in the States with 40-45% market shares. So, it's really… and all of these companies - or most of them, are on pretty low or depressed valuations, reflecting, I suppose, poor sentiment about the outlook. But actually, if you look through that, these companies are very well positioned into medium and long term. The house builders we own typically are trading below their asset value, which is really land and half-built houses. So that's pretty unusual to find those companies at those valuations. So yeah, when we look across that whole industry, we find a number of companies that are really quite depressed, even though trading isn't always as bad as people assume it might be from the outside.

JC: As you’ve said on a number of occasions before on this podcast, Simon, that those businesses that you're invested in, of course, do have exposure to beyond the UK, to the global economy, as you say, to the United States where things are very different. Where the economy is in a more positive position.

SG: Absolutely. Firstly, you've got a massive infrastructure expenditure of the Inflation Reduction Act in America, huge government support to spending on infrastructure, construction, and so on. Also, the housing market has proved remarkably resilient. One of the odd things about the American market is people can refinance the mortgage whenever they like, whenever interest rates go down. And what's happened is people have been sort of locked in. They've now got 30-year mortgages at quite low interest rates. The headline level is very high now. So, if they were to move house, they would have to pay a much higher mortgage rate, which means very few people are moving house. The number of houses on the market, I think, is at record lows for 40, 50 years. But that means if you want to buy a house, you almost have to buy a new house. So new house construction, ironically, is actually quite high, even though mortgage rates are high, because there's such a shortage of second-hand homes, if that makes sense. 

JC: Absolutely.

SG: So the market's doing better than people thought it would. 

JC: So, buy new is the mantra if you're looking for property in the States? 

SG: Well unfortunately that's the only option in some cases because there aren't that many second-hand homes coming onto the market. 

JC: Just a quick thought on insurance as well, you mentioned that as an area that you're interested in at the moment.

SG: Yes what's happened… we've had high claims inflation across a number of insurance markets, domestically in the UK in motor policies, the cost of inflation has gone up significantly, but if you look more globally because of a lot of severe weather events, and hurricanes and so on, you've seen a number of years where the insurance industry, certainly the reinsurance industry, was losing money or not making very good returns. And so, they've pushed prices up very aggressively, both domestic motor but also reinsurance. And companies are starting to benefit from that. You're seeing profits, forecasts, improving, companies starting to make good returns. And there's no sign that those price increases are fading yet. In fact, if anything, they're still pretty strong. So we saw quite recently a special dividend at Lancashire, which is a reinsurance company, Admiral have reported improving conditions. So, we're seeing better trading conditions coming through in insurance and it's an area we like. They're also beneficiaries of higher interest rates because they take customers' money and sit on it for a while until they pay out claims. And as interest rates go up, over time they can make better returns on that cash.

JC: So, we started this conversation noting the depressed sentiment that the UK economy has gone through, but we saw that there were also reasons to be cheerful as well. So how about you Simon, where do you sit in this? Are you broadly optimistic about the outlook for the coming six months, as we look into 2024? Are you cheerful about how the UK economy might perform? How those investments will perform?

SG: Well, I think those are two very different questions, it's really interesting. The UK economy and the stock market are very different and just to remind people, something like 70% of sales and profits of UK-listed companies come from abroad. So, I'm not particularly optimistic about the outlook for the UK economy. We could have a recession. We might avoid it. I think it's quite hard to call it. Either way, though, I suspect interest rates are close to the peak because inflationary pressures seem to be coming down. And certainly, if we had a recession, then inflation should come down quicker. Having said that I'm quite optimistic for the UK stock market, not specifically for the next six months, but in the medium to long term. Timing is almost impossible in the market, but valuations are at a 20-year low and within the market the dispersion of valuations is extremely high. So, there are fantastic opportunities to buy companies that are well financed, strong businesses, often globally exposed on very modest valuations and that has historically been a good time to invest because the returns you get from investing are often linked to the price you pay for the assets and at the moment, the prices are very low. So, I'm optimistic about the markets and the three to five-year view. I couldn't really call the next six months and I think the economy, you know, it could be challenging for the next six months. 

JC: Well, it'll be an interesting journey come what may and we'll look forward to joining you on that journey in future episodes of the podcast, as well. But for the time being, Simon, we're out of time. Thank you very much indeed for your time.

SG: Thank you. 

JC: And thank you for listening to A Value View from the Merchants Trust. You can find out more about the Merchants Trust and read and watch Simon's latest investor notes by going to merchantstrust.co.uk. Thanks for listening and until next time from all of us here at the Merchants Trust, it's goodbye.