8 Dec 2020
I am often asked what do I enjoy most about being a fund manager. My standard response is that there is such great variety as no day is the same, markets constantly evolve and there is such a broad range of issues to be on top of. The reality is that markets and economies typically evolve slowly and so the excitement one describes can be somewhat overdone. This is particularly the case if, like me, one is a long-term investor with a historical turnover of less than 20%. However, 2020 has been a year like no other and without doubt more stressful than 1998, 2000 and 2008 when we also saw severe market dislocation. Yes the day job has been similar in meeting companies, clients and analysts (albeit all done from an upstairs bedroom) but the pandemic has meant that this has been against a backdrop of such accelerated change and market volatility that it is worth pausing to try and unpick the consequences.
The crisis this year has accelerated many of the trends that were already in place before the word ‘coronavirus’ entered the everyday lexicon. I am convinced that although we may have a vaccine soon and life will regain some semblance of normality in 2021, the consequences of the pandemic for markets and economies are long lasting and deeply structural. While the short-term outlook is probably more in the hands of scientists than politicians and central bankers, there has probably never been a more difficult or important time for policy makers to ensure they navigate a very treacherous medium-term outlook. I wish to explore what those trends are, what they mean for the investment outlook and how we propose to manage them in the context of the Ninety One UK Alpha Fund.
There is no doubt that the way we consume, work, travel and communicate was changing long before the pandemic. However, many of the trends that have accelerated, such as home working, online shopping and increased internet usage, are here to stay. The UK equity market is not deemed to be technology heavy at a sector level, but every company now has technology embedded in their business. What really matters is how they use it to augment their business model. We want to ensure that we own companies that come out of the pandemic in a stronger position than when they went in and some of the opportunities are not in the places one might naturally expect to find them.
One such example would be the clothing retailer Next, which we bought through the crisis1. While you will read below that I am worried about the outlook for the UK consumer, Next is a very well run business, with a superb online distribution model and a competitor set that in many cases will not survive the crisis. Next has always embraced technology and therefore is a stronger business because of the crisis, not weaker. We also bought Ascential, a specialist information, data and analytics company that has a fast-growing business called Flywheel that optimises digital retail for the world’s largest manufacturers, and we have also been able to add to companies like GB Group that is still growing due to its strong position in online fraud and identity verification.
The existing trend of consumers moving online has accelerated due to the pandemic
Source: Barclays and Bank of England calculations. All retailing excluding automotive fuel. Latest observation is for September 2020.
Companies do not operate in a bubble and the economic outlook is incredibly important. We have just had the largest peacetime shock to the global economy on record and yet one would assume from the strength of markets that once a vaccine is delivered it is business as usual. I believe nothing could be further from the truth and many of the weaknesses of the UK economy before the pandemic have only been exacerbated further. The Office for Budget Responsibility (OBR) is now forecasting an 11% fall in UK GDP for 20202, the largest annual drop since the Great Frost of 1709. At the same time, the global economy is forecast to fall 4.4%. I have always told clients that there is only one number that they need in order to monitor the UK economy and that is the savings ratio (the percentage of disposable income that is saved).
Over two-thirds of UK GDP is domestic consumption and the significant falls we have seen in GDP mainly reflect the rise in the savings ratio from 5% to as high as 28%. Of course, much of that increase in savings has been forced as consumers could not spend and so the rebound in the economy will reflect the subsequent fall in the savings ratio as shops re-open.
However, the OBR assumes that we retrace back to the previous low levels of savings and consumers spend as they did prior to the pandemic. I just do not see that as credible as we will be in a period of higher unemployment and increased economic uncertainty. I believe precautionary savings will remain elevated and thus the ability of the UK economy to rebound quickly is very unlikely. If one overlays a very poor outcome from Brexit, which is increasingly likely (no deal or a very thin trade deal), then there are tough times ahead for the UK economy.
The OBR expects the savings ratio to swiftly return to previous levels; we disagree
Source: ONS, OBR, Economic and fiscal outlook, November 2020.
In the Fund we have therefore tried to minimise the asymmetric risks that both a no-deal Brexit and a prolonged recession might bring, neither of which are consensus for the market. We had already neutralised currency exposure and reduced cyclicality prior to the pandemic reflecting our concerns of a disruptive Brexit deal and the elevated probability of UK economic recession risk. Today, we remain neutral sterling exposure, with less than 30% of the portfolio’s revenue generated domestically, down from closer to 40% back in 2016. This should shield the portfolio from any sizeable currency swings relative to the wider market. We also seek to mitigate the economic risk of the portfolio by only buying more cyclical names when we believe a stock’s valuation is pricing in a severe recession.
We have focused our cyclical exposure on names that have strong balance sheets relative to their sectors, which should allow them to weather the difficult and uncertain environment in which we find ourselves. So, for example Ryanair3, being the lowest cost aircraft operator with a very robust balance sheet, should be able to weather the current difficult trading environment and emerge from the crisis in a better competitive position than when it entered.
The final trend is one that may not fully play out for many years but is probably the most important for long-term investors. Can regulatory authorities navigate a path back to growth and out of the increasing constraint of government debt?
Following the oil crises of the 1970s, developed economies have spent much of the last four decades in a neoliberal era represented by free trade, free movement of people and independent central banks. Monetary policy has been the dominant policy tool with which crises have been fought globally. Every time there was an economic downturn, interest rates were cut, consumers and governments borrowed more cheaply, and economic growth was stimulated. For the last ten years, however, the buffers of traditional monetary policy have been hit, with rates around the world at or close to zero and, in many cases, real rates in negative territory. We may even have negative policy rates in the UK soon. Quantitative Easing (QE), which was initially described in 2008 by the Bank of England as a short term, non-conventional policy tool designed to bring solvency to the financial system, has found itself twelve years on now presented as a long-term, conventional policy tool designed to bring liquidity to the financial system.
I argued for years before this crisis that QE was not going to drive improved economic growth as I do not believe that the process of the Bank of England buying financial assets with an expanded balance sheet has a credible transmission mechanism in to the real economy. QE does not make consumers spend, or businesses invest. In economic terms it increases the money supply but does not necessarily increase the velocity of circulation of that money in the economy. The pandemic has thrust QE once more into the limelight as the UK Government has seen a forecast £57 billion fall in tax revenues in 2020 and a £281 billion increase in spending. The Debt Management Office is therefore selling billions of pounds of gilts every week to fund the £394 billion annual deficit in 2020. It is not an accident that the Bank of England has increased since March the amount of QE targeted by £250 billion to £895 billion.
Effectively the Bank of England is financing all of the Government’s significant gilt issuance. The Bank’s actions will have expanded its own balance sheet from 27% of pre-COVID GDP to more than 50% in 2021. That is more than double its largest ever size in the previous 326 years of the Bank’s existence. Many argue that there is nothing wrong with this as interest rates are so low and there is truth behind that statement as debt interest spending to revenue has fallen to 1.7%, a new historical low4. The reality though is that the UK has become increasingly vulnerable to any future rises in interest rates off the back of inflation, credit risk or even growth.
The Bank of England is effectively financing the Government’s gilt issuance
Source: Office for Debt Management, Bank of England, Ninety One calculations, 25 November 2020.
*Cumulative net Gilt issuance in 2020.
**Cumulative change in BoE's 'Asset Purchase Facility' in 2020.
Why is this important for the Fund? Well, the shape of the yield curve has been a significant driver of equity returns because lower interest rates have enabled a revaluation in real assets such as equities as the value of future cash flows is higher because they are discounted at lower rates. In particular, higher quality equities, that have greater certainty of cash flows further out, have been re-rated. In the Ninety One UK Alpha Fund we therefore have a diversification by style such that we do have a core of the portfolio that reflects those higher quality stocks, such as Diageo, Experian and Unilever5. However, we are aware of the risks of a steepening yield curve and so we own names such as Charles Schwab and Lloyds who provide us with protection on that scenario.
In conclusion, the pandemic has left the world and, in particular, the UK in a very uncertain place. In constructing a portfolio, we can still find many opportunities of companies that can still grow, have embraced technology and will exit the pandemic in a strong position. However, we are also very cognisant of the economic risks and the fact that macro-prudential policy is very strained as central banks use increasingly esoteric tools to stimulate economies.
There is no doubt that the consequences of the pandemic are real. Previous trends such as those we highlighted have been significantly accelerated and less than a year on, we find ourselves in a deep recession, with government balance sheets completely transformed and a step change in how we use technology. This time it is different and the world will not revert to the previous status quo. The key for the Ninety One UK Alpha Fund is therefore to have a diversified approach and own those companies that can navigate a world of geopolitical stress, economic uncertainty and structural change.
1. No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided. This is not a buy, sell or hold recommendation for any particular security. For further information on specific portfolio names, please see the important information section.
2. Office for Budget Responsibility forecast, November 2020.For professional investors and financial advisors only. Not for distribution to the public or within a country where distribution would be contrary to applicable law or regulations.
3. This is not a buy, sell or hold recommendation for any particular security. For further information on specific portfolio names, please see the important information section. For professional investors and financial advisors only. Not for distribution to the public or within a country where distribution would be contrary to applicable law or regulations.
4. Office for Budget Responsibility forecast, November 2020.
5. No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided. This is not a buy, sell or hold recommendation for any particular security. For further information on specific portfolio names, please see the important information section.For professional investors and financial advisors only. Not for distribution to the public or within a country where distribution would be contrary to applicable law or regulations.