Twelve months ago, when we were advised to work from home one last time as Omicron swept through the country, I decided to use the enforced break from the hustle and bustle of the city to reflect on what had been a wild ride for markets through the pandemic.
I ended up turning more cautious on the outlook as the post-vaccine optimism around a 'roaring twenties' for markets seemed misplaced with inflation picking up and the first signs of labour tightness (remember the petrol tanker shortages?) leading the Bank of England to start raising interest rates.
Despite reality turning out far worse than my expectations, with the war in Ukraine pouring fuel onto the inflation fire, today I am far more excited about the opportunity in UK equities than I was a year ago.
Have we already passed peak perceived risk in the UK?Not because the fundamental outlook is improving – it is tough and getting tougher – but because this is now a widely accepted view.
Newspapers are full of gloom and doom; workers are on strike and previously upbeat government ministers are telling us to brace for a tough winter.
Importantly, from an equity market perspective, this means share prices are starting to reflect this reality. As a result, we are seeing selective opportunities to pick up high-quality businesses at attractive prices.
Having cut cyclical exposure earlier in the year, we have reversed course and begun adding exposure to companies whose share prices have performed poorly through 2022.
So where are we finding opportunities? Despite the FTSE All Share being one of the best-performing equity markets, delivering a positive year-to-date return with dividends included, this masks significant divergence between constituents.
For example, within the portfolio we have strong performers like Shell up 50 per cent while Next and Domino's Pizza are down 25 per cent and 35 per cent respectively.
Given we have not revised our long-term views on any of these companies we have begun moving capital out of Shell and into holdings that we believe are already discounting the extremely tough outlook for the UK consumer economy.
Will Next and Domino’s see their earnings forecasts come under pressure over the next twelve months? Absolutely.
Will their share prices remain volatile? Probably.
Are they good value on a three to five-year view? Absolutely.
The key thing to remember in these challenging times is that the falling share prices of companies with a poor near-term fundamental outlook are making them more attractive investments.
As human beings we are prone to get too optimistic when the outlook is rosy and profits are rising, as they were for much of 2021, and too pessimistic when the headlines turn negative, as they are now.
We try very hard not to fall into this trap and focus on making disciplined decisions based on our assessment of value and long-term outlook, and this is what is leading us to increase exposure to areas of the market that have fared poorly this year.
Another group of companies that have performed poorly this year are those that have suffered from escalating costs, be they second-hand car prices (Admiral Insurance), freight costs (Fevertree) or animal feed (Cranswick).
Unlike the consumer-exposed companies mentioned above where demand fundamentals are still deteriorating, for this group the outlook is stabilising as we are seeing early signs of cost increases moderating as supply chain pressures ease.
Many investors have been discouraged from investing in the UK following the political upheavals of recent months, and sentiment really soured following the "mini" Budget in September.
Paradoxically, these events have increased my confidence in the strength of UK institutions, which moved quickly to get things under control and has led to a recovery in the pound and falling borrowing costs.
Can the same be said of all countries to which UK-based investors allocate capital to on their clients’ behalf?
A former colleague once told me: “Actual risk is equal to the inverse of perceived risk.” Have we already passed peak perceived risk in the UK?
While the environment still feels very uncertain as we move into 2023, I think it is time to channel our inner Warren Buffett and remember to be greedy when everyone else is fearful.
Aruna Karunathilake is a portfolio manager of the Fidelity UK Select Fund at Fidelity International
