In conversation with…Mark Barnett and Martin Walker
Article | 04 May 2017
UK Equities Product Director, Hilary Cook, discusses UK equity market developments and opportunities with Head of UK Equities, Mark Barnett and Fund Manager, Martin Walker.
HC Mark, what has caused the pick up in UK equities since the initial volatility in 2016?
MB In part, this has been driven by an improvement in aggregate market earnings. Reported corporate earnings had been improving over the course of the year but this was driven further by the sharp fall in sterling which had an influence on the performance of the market. In the fourth quarter of 2016 and the early part of this year, there were increased levels of optimism around global growth and, following the election of President Trump, optimism around anticipated reflation policies that he might be embarking on to help spur the US economy further forward. Is it sustainable? I suspect gains of the same order will be difficult to achieve over the coming 12 months.
HC Mark, the fixed income and foreign exchange markets have had a significant impact on how the equity market has behaved. Do you expect this influence to continue and how much is it impacting on your portfolios?
MB Wider influences have, as you say, had a significant impact. The UK Government bond (gilt) yield collapsed sharply in the first half of 2016 and retraced all of that fall in the second half of 2016 (see Figure 1). That, in itself, was a big driver of the breakdown of equity returns. And allied to that, you had, post the referendum, a very sharp devaluation in sterling (see Figure 2). We must remember that the UK market is very international and a large proportion of the UK market’s revenues is non-sterling-denominated currencies, so the sterling devaluation had a big impact on the market and, as I said earlier on, positively impacting forecasts for aggregate market earnings.
Source: Lazarus Partnership, as at 1 March 2017
Source: Lazarus Partnership, as at 1 March 2017. Sterling Exchange Index Rate - a measure of the value of the pound that is calculated according to how much trade we do with different countries and in various currencies.
It is likely to continue? It probably is at a sector level, particularly given the sharp move in sterling. The direction of the currency will continue to have a pretty big impact on the direction of the market in my view. In terms of my positioning, I’ve been trying to focus more on domestically-focused businesses, where in many cases, their market value seems to be at odds with their fundamentals. As a result of the fall in sterling, the market has taken quite a pessimistic view of the performance of domestically-focused businesses across a range of sectors, where I’ve been seeing opportunities.
HC Moving on to sector and stock-specific questions, we saw ‘Brexit’ trigger a huge shift in markets; at sector level there was strong correlation between stocks (i.e. their share prices moved in line with one another). Mark, when do you think we might see a stock-pickers’ market again?
MB That’s a tough one to call because the market has been very sector driven. My sense is that sector influences won’t go away, but there might be more differentiation within those sectors. I think it isn’t too much to expect that, going forward, we might see fewer aggregate sector shifts and a greater degree of variation between individual stocks - but it’s a very difficult one to call. Ultimately, investors should be reassured that we are not changing how we manage the funds.
HC Martin, a year ago you had a large position in the mining sector, relative to the benchmark, correctly arguing that it was heavily undervalued. Is that party now over?
MW I think, to some extent, it probably is. This time last year, under some very extreme commodity scenarios, the sector looked undervalued. Bear in mind that this time last year many commodity prices were trading at significantly below the cash cost of extraction of those commodities, so that level of price always felt unsustainable. I think we’re in a very different place today. There has been a significant re-rating of the sector. Whether the share prices are undervalued today really depends on what you believe commodity prices should be going forward. I’ve spent a lot of my career talking to commodity analysts. I’ve come to learn that no-one really has any strong insight into this.
I’ve taken down my weightings in the sector given recent strong performance; my position in the sector is now significantly underweight, relative to the benchmark. I’ve focused my holdings in the sector on exposure to base-metal areas, like copper, which I believe to be fundamentally challenged in terms of supply going forward.
HC Mark, the pharmaceutical sector is the largest sector in your portfolios. This sector had a tough 2016. Are there signs that 2017 could turn out better?
MB Through the US election campaign we saw concerns around future US drug-pricing weigh heavily on the share price performance across the sector. I think these issues are now much better understood and much more fully reflected in share prices. Pricing pressures will continue to be a major issue for the pharmaceutical sector, but I believe that drug companies, through new science and new innovation, can work around some of the bigger, political issues. I think the backdrop for the sector is still positive, given the ageing population and the demand for western-style medicines in the emerging world as well.
The sector is broad. It includes a whole range of businesses from the very largest global, multinational pharmaceutical companies to much more niche, speciality pharma or biotechnology businesses, and I hold a number of those. I do think that the market is too pessimistic about the sector. There are good grounds to believe that the new areas of drug discovery are likely to deliver better outcomes – and that, in my view, is not currently reflected in share prices.
HC Mark, 2016 was noticeable for some very large share-price movements. How hard is it to hold your nerve when a share price falls so rapidly?
MB It can be a very tough place to be, but ultimately, it is crucial to avoid reacting in the moment. You have to remain focused on the long term and think: ‘What does this mean for the company’s longer-term outlook? What does this mean for the valuation of the stock? How has the market become dislocated from the value that you have attributed to the company? Because the market is very sensitive – and has become even more so over the last few years – shares are often sold way below the fundamental value of the business due to short-term thinking being extrapolated way into the future.
Investment risksThe value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Where Hilary Cook, Mark Barnett and Martin Walker have expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.