“Buy the first rate hike and sell the penultimate one” is an old stock market adage. Interest rates are usually rising when the economy is expanding and doing well while rates being cut are a sign of the economy weakening and needing a boost. If rising interest rates is a good sign for the economy why is there concern on the outlook for rates and inflation?
Source: Bloomberg; 3 February 2022.
Before we start, it is worth noting that the much more sinister problem for the UK would be if we were not seeing an inflationary pick up. Let us remind ourselves of what the past two years have seen in terms of monetary and fiscal policy. Interest rates were cut in the pandemic to 0.1%, levels not seen for centuries; the Bank of England undertook a whopping £895bn of quantitative easing; and perhaps the most eye-catching of all, we saw direct fiscal stimulus from the government of around £400bn. These measures were designed to protect the economy and jobs from the exogenous shock of COVID-19 and they have been successful. GDP has rebounded faster than many expected, unemployment is thankfully very low and many of the worst-case scenarios have been avoided.
The unprecedented policy response worked – job done?
Sadly not. Central banks now find themselves with an equally difficult task of how to unwind these huge economic stimuli in a way that does not knock the recovery off course. If they raise rates too slowly, inflation could get out of control; raise them too fast and the economic recovery that has been so hard fought will falter. This is a difficult tightrope to walk. Part of the current volatility in markets is in no small part due to central banks’ commentary being erratic. They pretended for far too long that the inflation being seen was transitory, and now both the Bank of England and the Fed are in danger of swinging to the other extreme and being too hawkish. We are going to need a measured and controlled monetary response throughout 2022.
Mathematically, the inflation data will start to roll over from April as we annualise against higher oil prices. Higher prices from supply-chain disruption and port congestion should ease somewhat as life returns to normal. Other parts of inflation, in our opinion, are likely to remain more persistent. First, unemployment is thankfully low and job vacancies are high; workers are unlikely to give up their bargaining power. Second, the 30-year trend focusing on supply chains as the cheapest solution and carrying the lowest level of inventory possible is likely, after the shocks of the past two years, to leave many more businesses focused on just-in-case supply chains and greater resilience of inventory.
Where does this leave the UK consumer?
High inflation is driving up non-discretionary bills such as utilities and food, and taxes are rising to pay for the pandemic spending, all creating a tougher environment. Offset against this are higher wages and the wealth effect of rising house prices, so the UK economy is well placed to snap back in 2022, potentially delivering GDP growth of c5%. The key factor helping the UK consumer navigate the current rising prices is the £185bn of excess savings that have been built up in the past two years. This is not to belittle the enormous challenges ahead and we should expect continued government help where it is needed most, but these savings and the current strong labour market do mean the consumer has a greater resilience to cope with this inflationary bump.
The impact on markets and our positioning
The magnitude of stimulus seen around the world, coupled with the huge monetary policy response has led to clearer excess in valuations in the stock market, especially in parts of the US. The chart below is the Goldman Sachs composite of the performance of unprofitable technology shares showing while it has halved there is still plenty of the excess to unwind.
Source: Bloomberg; 3 February 2022.
Now that monetary policy is normalising, some of the more traditional and boring rules of investing such as cash flow generation and valuation are powerfully re-exerting themselves. The UK stock market has hugely lagged other developed markets and on many measures finds itself extremely cheap relative to those markets. We believe this valuation discount should now be a source of returns.
Positioning of the Polar Capital UK Value Opportunities Fund
We hope our starting point of a Fund on a 15% discount to the UK market and sitting on just over 10x P/E is a good basis for making returns in a world where valuation now matters. Sector-wise, we have 20% in financials, clearly a part of the market that benefits from rising rates. Banks and insurance companies have been delivering decent earnings upgrades and beats and a steeper yield curve gives a good basis for this tailwind to continue.
Materials is another important exposure, at over 14% of the Fund. Holdings here range from attractively-valued copper mining companies like Atalaya Mining, trading on just over 5x P/E, to paper and packaging company Mondi and construction materials company Breedon Group. All of these businesses have a unique advantage in an inflationary environment – they own their key input costs of resources in the ground (or trees if you are Mondi).
Food retailers have historically done well under inflationary environments, and here we have exposure to Tesco, Sainsbury's and Marks & Spencer Group. All these businesses have modest valuations, significant asset backing in the form of real estate assets and healthy cash generation. Curiously they all trade at substantial discounts to the levels at which private companies have felt comfortable buying both Morrison Supermarkets and Asda.
The year ahead is likely to prove more volatile as markets and investors adjust to the fact that the outlook for inflation and interest rates is changing. However, a focus on attractively-valued companies, with strong balance sheets and healthy cash flows should prove a good basis for making returns.