UK equities: Investors’ three big questions answered by Artemis

More important is that the agreement removes the barrier to allocating flows to the UK market. We are now on a more level playing field with other equity markets. This reappraisal of the UK market will take time but, interestingly, with £47bn of UK companies taken over in 2020 some are in more of a hurry!

The portfolio is positioned to benefit from the total return that accrues from long-term cash flows which are attractively valued. In other words, we have not made any radical changes pre and post the agreement.

Ed Legget and Ambrose Faulks, Artemis UK Select Fund: 

It has brought more clarity. The removal of the cliff-edge, no-deal Brexit has taken away the market’s greatest fears. The muted share price reaction since is due to concerns over the UK’s third major lockdown. And therein lies the rub: Covid substantially trumps Brexit. 

It will take some time to discover the true economic cost of leaving the EU. Some sectors will see little change – albeit many sectors have ‘phase-ins’ – and others will face more customs declarations. The list of unknowns reduced rapidly and we would expect a high degree of automation to come shortly. If that were the sole upside to leaving, you might very well question why the UK voted to leave.

We would posit a quick thought: remaining in the EU would have meant we joined the EU’s vaccine purchasing schedule. Limited pre-purchasing has led to a slower roll-out than elsewhere and shown that one size does not necessarily fit all. Finally, since the start of 2016 (referendum year) to November 2020, the UK market saw just shy of £120bn outflows from global investors. Could a reversal be on the cards?

Derek Stuart, Artemis UK Special Situations Fund: 

The main effect of the Brexit deal is to remove another obstacle for investors to invest in the UK stock market. While we do not yet know all the details or implications of the deal, the threat of a ‘no-deal’ was still very real in the minds of many investors. Given the political and Brexit noise over the past few years, investors have been reluctant to invest here.

This has left the UK market as one of the cheapest globally, at a time when a majority of asset allocators have very modest weightings to the UK. This valuation is already being recognised by corporates and private equity, with acquisitions of UK companies accelerating into the year end. We expect that to remain a feature in 2021. 

2. Which sectors are likely to undergo most change in 2021?

Income:

The UK market will benefit from any reflation trade, given its value tilt. Financials and commodities would be obvious beneficiaries. Financials exhibited resilience in late 2020 as fears of delinquencies faded, along with pressures on net interest margins. We expect this resilience to become an attraction as investors rotate away from other parts of the market – and we envisage the resumption of dividends in 2021.

Commodities are likely to be much more prominent in 2021 than last year. Sustained demand from China will be buttressed by increased activity in the West, post-vaccine. And then there’s the increased focus on green issues within fiscal stimulus packages. Decarbonisation and broad ESG factors are becoming structural drivers on the demand and supply side, and growing climate ambition is set to boost demand.

Away from these two sectors, our main observation is that strong companies who survive this disruption will gain customers as rivals disappear. So while certain industries may have shrunk and so offer a smaller pool of revenues, they may be shared between fewer companies.

We would remind investors that we are looking at sustainable cashflow over at least 3-5 years, with an average holding period of 6+ years through a diversified portfolio, which is currently around 50 stocks. While these are thoughts on sectors that could change in 2021, we are bottom-up investors taking a long-term view on our investments which we prod, poke, hypothesise on and re-test on an ongoing basis.

UK Select:

This year is likely to see substantial market rotation, building on the moves at the end of 2020. Over time, we expect bond yields to move towards expectations of long-term inflation. As long-term interest rates rise, near-term cashflows are more valuable, outer years less so. In a word: value. We seek companies of high quality which have been mis-priced. Many of those have been value stocks. And it has been a long, hard, cold winter for value. We now smell spring for what we hope to be a long Indian summer.

Against a backdrop of steepening yield curves, we expect global asset allocators will move toward value-oriented parts of the market, and to real assets. Commodities and emerging markets should benefit, but we are fortunate to have the UK as our focus – a value market! And within that we hold a portfolio of undervalued, growing and high free-cashflow stocks.

Aside from bottom-up stock insights, we would expect our performance to be driven by three meaningful factors: (i) Covid recovery/back to work stocks. For example, airlines and financials. People will fly again. Bank impairments should be more benign, and credit concerns for insurance businesses should ease. Moreover, we see pent-up demand from the consumer.

Many of 2020’s winners will become 2021’s laggards – DIY, bicycles and the making of banana bread will drop down agendas. (ii) Brexit recovery. Improved certainty will allow more investment decisions – be it construction, loan growth and beyond. (iii) Value. Rotation into businesses delivering cash today not tomorrow. Within that, we would see risk to the sustainability of multiples for some prominent tech-oriented businesses in the US.

UK Special Situations:

Clearly the pandemic has accelerated structural change. While we do not believe most people want to work from home all the time, the balance between home and office has clearly shifted. Property and commuter transport may well remain under pressure.

The main focus for us has been on those sectors where capacity has reduced and the survivors should hold a better competitive position. Retail, leisure and hospitality are all areas where capacity has been reduced – but which we also believe will benefit quickest when restrictions are removed. The evidence of last summer – when restrictions were reduced – was a spike in demand for airline bookings and visits to pubs and restaurants.

We have increased our exposure to all three of these sectors in anticipation of a pick-up in demand during the second half of 2021. We also believe the construction sector will benefit from the increase in fiscal stimulus. The government has already committed to HS2, a new road programme, and ‘green energy’ will require significant infrastructure investment. It is quite clear the current government is not a government of austerity!

3. What could disrupt the outlook for UK equities?

Income:

Overall, we think the UK market has the ingredients for better performance relative to other markets. And that corporate fundamentals are much better than one would have feared just a few months ago. While too much inflation would upset global markets broadly, the UK is better placed than many.

In our view, the primary determinant for further disparate performance is bond yields. Rising yields will put further pressure on the valuation of growth stocks and certainly improve the performance of value – in relative if not absolute terms. A strong recovery in economic growth, with plenty of stimulus in place, could worry bond investors. However, to create enduring outperformance value stocks will need resilience of profits and cash flows.

On the whole, we believe our companies are well positioned as we exit lockdown. Over the past three months, one notable feature was that companies – particularly those businesses that find themselves directly in the path of the coronavirus storm – are coping better than feared. Rates of ‘cash burn’ or losses were more contained than previously thought. This helped to offset the disappointment that the disruption caused by the pandemic might be prolonged. However, any delay to vaccine rollouts or further strains of Covid, could further push out the recovery. 

The dividend of the UK market will have fallen by about 35-40% in 2020. We expect there will be some growth in dividend payments in 2021 and more so in 2022. Any pushback in the recovery could lead to disappointment in the scale and speed of dividend recovery.

UK Select:

The two greatest Achilles heels: vaccines and interest rates. Should the vaccines turn out not to work as effectively as trials, or should they develop unforeseen side effects, this crucial circuit breaker would go back to the drawing board. We take comfort that there are already three approved vaccines in the western world, with Johnson & Johnson hot on their heels. The second vaccine risk would be the roll-out strategy. 

First, logistically. At present we are extremely impressed with the UK’s judicious purchasing and the ramping up of vaccines – with the recent news leak of a target of 0.5m vaccines per day. We are puzzled by stories of reluctance to take vaccines in France. Frankly, this is a race. Of large developed world countries, the UK is leading the marathon over the first half mile!

Second, if for some reason there is further monetary policy to hinder the rate rises implied by markets, the value trade might be like Groundhog Day’s Punxsutawney Phil for a little longer. We expect short-term interest rates to remain low – but longer-term rates are likely to be driven by expectations of the impending economic recovery. This, in turn, is predicated upon vaccines ending Covid-19. Thus there is a high degree of circularity.

UK Special Situations:

In general, we believe the issues that could disrupt UK equities are more global than national: the lingering effects of the pandemic on the economy and public sector debt. Given the levels of stimulus, we are still needing clarity on the real damage to the overall economy. And the need to finance the spending by government will ultimately force taxes up.

Bond yields will rise as investors price in this higher level of debt. Rising bond yields are fine up to a point. Indeed, they are generally more supportive of value stocks than growth. But if the adjustment in rates happens too quickly, there will be contagion across all asset classes.

More specifically, the UK may suffer from higher inflation as a result of Brexit. We view the upward pressure on bond yields as potentially being the most disruptive influence across all asset classes but, as noted before, this is not just a UK issue. 

Finally, a note on earnings forecasts and momentum. The second half of last year benefitted from a constant upgrade cycle as the conservative forecasts set in March and April were revised upwards through the year. This supported the re-rating across the market. That won’t continue throughout 2021. Indeed year-on-year comparisons will become tougher from the second half of 2021.

Adrian Frost, Nick Shenton and Andrew Marshmanage the Artemis Income Fund. 

Ed Legget and Ambrose Faulks manage the Artemis UK Select Fund. 

Derek Stuart and Andy Gray manage the Artemis UK Special Situations Fund.