Matthew Tillett
Premier Miton UK Value Opportunities Fund Manager
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
In this insight note we cover
- Ever since 2016 there have been continual predictions of economic crisis in the UK. Whilst GDP growth has been below trend, these crises have not come to pass, suggesting that the UK economy might be more resilient than most people think.
- The current crisis story follows two months of higher-than-expected UK core inflation, leading to upward revisions in interest rate expectations and an increasing risk of a housing crash and recession.
- Whilst this outcome cannot be ruled out, historical evidence suggests that it is unlikely that the UK follows this path whilst the rest of the world goes in the opposite direction. There is currently evidence that broader inflationary pressures in the global economy are receding, which in time may benefit the UK.
- From an investment perspective, we think this situation may create long term investment opportunities in domestic UK interest rate sensitive stocks, such as in the consumer discretionary and real estate sectors.
Hey buddy, can we catch a break?
Lately it feels as though the UK economy just can’t catch a break with investors. Back in 2022, it was all doom and gloom due to fears of a deep and imminent recession. The IMF predicted the UK economy would contract by 0.3% in 2023 (they have recently upgraded this to 0.4%), the worst of any OECD country.
Fast forward to today, recession has been avoided (so far), employment has remained robust and consumers are in a marginally healthier position with utility bills falling and wages growing. In days gone past, this might have been celebrated as a success, but not so today.
For the UK economy, the prevailing bearish investment narrative is that good news is actually bad news because a stronger economy means interest rates will have to go higher causing an even worse recession further down the road. And yet back in 2022, when consumers and the economy really were struggling, bad news was also bad news!
Crisis seemingly follows crisis
This tendency to adopt the most negative narrative – a bizarre form of macroeconomic masochism – is something the UK has form on. For as long as I can remember, us Brits have had a strong predisposition to beat ourselves up at every opportunity. But it has gotten particularly bad since the Brexit referendum vote in 2016, since when, according to mainstream financial media, the UK has been continually on the verge of economic collapse, verging from one crisis to another.
Yet the predicted crises have never come to pass. In fact, looking at the entire period since 2016, it could be argued that the performance of the UK economy has been surprisingly strong, considering all the curve balls that have been thrown at it – severing relations with its biggest trading partner, a pandemic for which the country was poorly prepared, an energy and cost of living crisis, unpredictable and volatile politics, to name but a few. GDP growth 2017 – 2022 averaged 0.9%, down from 2.1% for the 2010-2016 period, and lagging the US at 2.0%, but more or less in line with France and Germany. For sure there are problems in the economy, but this is hardly the catastrophe that keeps being predicted.
The latest crisis narrative revolves around the path of UK inflation and interest rates, which, following two months of higher-than-expected core UK inflation readings, is now expected to follow a different and more destructive path than the US and the rest of world. In this note we explain why we think it is unlikely that the UK is on a materially different trajectory to other major advanced economies on anything other than a short-term view.
This negative narrative is causing investors to shun the domestic interest rate sensitive areas of the stock market. In contrast, we believe this is now one of the most interesting parts of the market to find company shares, with some opportunities presented in high quality companies that in normal times could be on far higher market valuations.
We do not claim to have a crystal ball when it comes to interest rates, but we aim to invest in companies that are already factoring in the higher interest rate environment. In recent weeks we have been investing more of the Fund’s capital to these areas.
Is the UK really an outlier?
Extreme bearishness towards the UK economy and domestic UK company shares has returned in full force in recent weeks. The catalyst for this has been, paradoxically, a stronger than expected economy. This has contributed to more persistent inflation than expected and, as a result, market expectations for peak interest rates have moved higher, with a consequent increased risk of recession.
We make no claims to be experts on inflation or short-term macro predictions. However, as contrarians, we do believe that we are reasonably good at spotting when investors have begun to extrapolate a short-term trend in a manner that might appear to contradict historical experience. We could well be in just such a situation now.
The chart below shows annual consumer price inflation (CPI) for the US and the UK economy. The choice of annual data here is deliberate. There is a lot of noise in monthly macro-economic data, which can often give false or misleading signals in the short term, whereas longer term annual data gives a clearer picture of the trends.
Source: Bloomberg, data from 1992 to 2022
Similar trajectories
The chart clearly shows that for most of the time, US and UK CPI readings are similar. Sometimes there have been differences of 1-2% but rarely more than this. Note also that the trajectories tend to be similar, with the UK often following the US. This should not be surprising. The US is the largest economy in the world and the UK is an open internationally oriented economy which trades a lot with the US. It is therefore unlikely that major macroeconomic trends impacting the US are not also going to impact the UK.
A similar picture emerges if we look at policy rates. Here again we see some differences from time to time, but they have tended to be in the same range and most of the time the trajectory has been similar.
Source: Bloomberg data from 1992 to 2022.
The prevailing narrative in the US is that inflation has peaked and is now on a steady path back down to trend. Whilst it is too early to declare victory, there is certainly evidence to support this view. For example, the New York Fed’s measure of inflationary pressure has fallen rapidly in recent weeks and is now not far off normal levels.
Source: Bloomberg data from 31.01.1995 to 31.05.2023
The recent move down in the producer price inflation series also supports this view. It was producer input costs (freight, energy, commodities) where the current bout of inflation first started back in 2021 arguably. Even in the UK, this measure of inflation is essentially back to normal now. The producer price inflation (PPI) tends to be a lot more volatile than the CPI, but if you look closely there does tend to be a correlation, albeit with a lag, between the PPI and the CPI. This makes sense as other areas of the economy play catch up following a period of input driven cost inflation.
Source: Bloomberg data from 31.03.1992 to 31.05.2023
One common argument for the UK being different is the seemingly tight labour market. It is certainly true that unemployment is at historically low levels. However, this has been the case for quite some time. Even before the pandemic unemployment was at low levels but there was little inflationary pressure.
Others point to the impact of Brexit, with less EU migrants in the workforce, but this also doesn’t stack up since inward migration to the UK has been surprisingly strong (2022 was a record year). Furthermore, if we again compare the UK with the US, we once again see a very similar picture both directionally and in absolute terms.
Different trajectories
When we look back on this recent period in years to come what are we likely to conclude – that this was the start of a very different trajectory for inflation and interest rates for the UK economy versus the rest of the world, or that the UK economy ultimately ended up in a similar place to the US and other advanced capitalist economies? We would argue that the evidence of history favours the latter.
The case for domestic interest rate sensitive stocks
As value-oriented contrarian investors, we are always on the lookout for situations where extremely bearish sentiment creates opportunities for us to make long term investments into quality business models at attractive market valuations. The peculiar circumstances outlined above are, we believe, creating just such an opportunity today amongst the domestic interest rate sensitive stocks. Here are two examples that illustrate the point.
The consumer – not all doom and gloom
The consumer discretionary sector has been hit hard as investors worry about the impact of rising mortgage rates on consumer spending, as well as the risk of a broader recession. This is an understandable concern, but it needs to be considered within the context of several other factors.
The impact on spending from consumers moving to higher mortgages will be a headwind, but it doesn’t happen all at once because mortgages are taken out with a range of fixed rate terms.
Furthermore, the Government and the lending banks have just announced a relief package which will allow consumers to make changes to their mortgages to reduce their monthly outgoings. This means the actual increase in mortgage payments may be considerably less than what the simple mathematics of higher interest rates suggest. Indeed, there is already evidence that this is happening – according to an analysis by the FT, so far in this tightening cycle, total mortgage payments have only risen by half of what would be expected by the rise in the interest rate, presumably as consumers have extended terms.
On the flip side, savings are now getting a proper return after years of seeing this dwindle to almost nothing. Meanwhile, those who are in work are receiving decent wage increases, whilst utility bills and energy costs are falling. Against this backdrop, it is perhaps not surprising that UK retail bellwether Next plc recently had a very strong unscheduled trading update in which guidance was upgraded due to much better-than-expected top line sales.
Consumer discretionary companies such as Next are also themselves major beneficiaries of falling input costs which will provide a boost to their profit margins. An extreme example of this is the upholstery market leader DFS, which has, over the past 18 months, seen its gross margin decline by a whopping 500 basis points and its overall profit margin fall to an almost record low. With the cost of key inputs such as freight and some commodities back to pre-pandemic levels, this is now a major positive earnings tailwind for companies such as DFS.
Real Estate – selective opportunities
Another classic interest rate sensitive area that looks especially interesting to us is listed real estate. This sector is amongst the most hated in the market, an obvious casualty of higher interest rates, as well as by its association with the well-publicized problems in the US commercial office subsector which is suffering from falling asset values and high leverage levels.
For the real estate operators that we own in the Fund, the outlook is positive. Most are operating in supply constrained markets where demand is running well ahead of supply, such as industrial logistics, student property or prime West End retail and hospitality. In these markets, rents are growing nicely, a trend which should continue as inflation is gradually recovered in rent reviews and lease events.
Critically, balance sheet leverage – so often the Achilles heel for the sector – is at historically low levels as the listed property sector has operated much more conservatively ever since the global financial crisis.
The final word
Finally, we believe most of the company share price pain for the real estate sector has already been felt. Despite company share values having already fallen quite a long way, property valuations may have a little further to fall if interest rates do remain elevated, but the point is that these stocks are already priced for this scenario. Something which cannot be said for many other parts of the stock market.
