In Liz, we trust?

VT Tyndall Unconstrained UK Income Fund

In Liz, we trust?

After a little over, what can only be described as, three highly eventful years, this week the UK says goodbye to the buccaneering ‘BoJo’ and welcomes a new Prime Minister, the fourth in just over six years, in the shape of Liz Truss. With a forbidding in-tray featuring surging inflation and energy costs, a cost-of-living crisis and potential recession to name but a few, is it a case that the UK, and UK assets, are doomed forever more or will it be a case of ‘in Liz, we trust’?

It is hard to fully assess the likely policy changes, their magnitude and potential impact coming from the new Truss team at this early stage as details, understandably, remain scarce. At face value there appears to be an ambition to revert back to the traditional Tory playbook of small government and low taxes, albeit potentially hamstrung in the short term by the urgent need to offer as much help as possible in the face of the ongoing cost-of-living crisis.

With respect to taxes, a Truss government appears set on reversing the increase in National Insurance that occurred in April 2022 and, potentially, cancelling the planned increase in corporation tax from 19% to 25% due in 2023. Other rumours include removing, at least temporarily, the green levy on energy bills and no introduction of further windfall taxes on energy companies.

Concerning the cost-of-living issues, Truss has committed to setting out a plan within one week of becoming Prime Minister, and whilst there are a variety of policy options, momentum seems to be building around a potential freeze on the energy price cap this autumn. Quite how that mechanism would work, who would be eligible and what the associated costs would be remains to be seen.

Other potentially thorny issues to be dealt with in due course include a possible review of the mandate of the Bank of England as well as addressing the outstanding Brexit related issues, most notably around the Northern Ireland protocol.

Whilst the in-tray appears somewhat daunting, we do not believe it is insurmountable. We have discussed many times before how UK assets, particularly equities, have been struggling to find supporters for several years now, at least since the 2016 Brexit vote. More recently, Sterling and UK government bonds have also seen significant weakness, in part due to the pressing issues of the day but also driven by fears over the potential cost of new policy initiatives, at a time when government finances are already stretched.

The chart above shows the sharp fall in Sterling against the US Dollar over the last 15 months or so, accelerating significantly of late, as Sterling approaches the Covid pandemic lows of March 2020. Meanwhile, the chart below highlights the aggressive recent increase in 2-year Gilt yields and just how different they look to any period in the last 10 years.

Notwithstanding the near-term difficulties, it will not surprise any readers to know that we see tremendous value on offer in UK equities currently, particularly in the more domestic areas of the market such as those in the Mid 250 universe. Many stocks have been suffering for some considerable time already, despite still trading well, driven by fears of significant economic weakness ahead. The chart below illustrates the c.26% fall in the Mid 250 (ex-Investment Trusts) Index over the past 12 months, with a great many of the most cyclical shares down 30-40% or more already.

The combination of the weakness shown above for mid-caps, and the relative strength of the FTSE 100 (being supported by energy, resources and more defensive stocks in general), is leading to a near record period of underperformance for mid-caps this year, as the chart below demonstrates clearly.

It will also come as no surprise to hear that we remain less bearish than many about the economic outlook. For sure there are meaningful headwinds to growth that will be with us for a time. However, we remain convinced that the ‘starting conditions’ as we entered this period of difficulty were materially stronger than usual, particularly as it relates to the strength of consumer, corporate and banking sector balance sheets.

Pulling it all together, we observe extremely bearish sentiment concerning the UK economy and UK related assets, to a very large extent already reflected in significant weakness/ underperformance of domestic cyclical stocks, presenting, in our view, extremely attractive valuation opportunities in a whole variety of companies and sectors that are simply too good to ignore on a medium-term basis.

Unlike the fanfare that greeted Boris Johnson’s appointment, our initial impressions are that expectations surrounding the new Prime Minister are extremely low. Just maybe it will prove, once again, to be ‘darkest before the dawn’ and who knows, perhaps the new Truss government will not only offer some much-needed near-term assistance, but potentially set out a genuinely credible plan to enhance the future growth potential of a post-Brexit UK. If so, that will definitely be something for investors in UK equities to cheer about in due course.

Difficult, yes. Impossible, we don't think so.

7th September 2022
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Data source (unless otherwise stated): Bloomberg
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