Following years of uninspiring performance, confidence in the UK equity market seems to have returned – helped along by news of the Covid-19 vaccines, the signing of the Brexit deal at the end of last year and plenty of fiscal and monetary stimulus globally. This combination has aided a meaningful rotation towards cyclical, ‘value’ parts of the equity markets. 
Mining, oil and gas and banking sectors have all experienced a surge since the start of 2021 – up 16.9 per cent, 16.5 per cent and 16.7 per cent respectively (total return in sterling between 1 January and 30 June 2021). These sectors were relatively unloved over the past few years, particularly those in the energy sector seen to be suffering from an irreversible tide of ESG scrutiny and a lack of demand – especially during the pandemic-induced lockdowns.
How cyclical is the UK?
In the UK, cyclical stocks are found in both the large and smaller cap space. Compared with the MSCI ACWI index, the FTSE 100 also has larger weightings in materials (12 per cent vs 5 per cent), energy (8 per cent vs 3 per cent) and financials (18 per cent vs 15 per cent). This is why our domestic equity market has often been termed a ‘cyclical tiger’.
As portfolio managers, we allocate to quality companies, which can find us at odds with a value rally. Around 70 per cent of our portfolios are focused on owning companies that are quality growth. But because there is cyclicality in some of the largest sectors of the benchmark, we cannot simply ignore those sectors all the time. So, we allocate an amount of capital to more cyclical names and the size of this portion will vary depending on the market environment.
Heading into March 2020, when Covid-19 struck the UK, we had been taking risk slowly off the table – we felt the oil sector was facing serious headwinds due to the amount of investment they would have to make in renewables for potentially little return, and we were cautious on financials because they also face a lot of disruption and had not seen much growth. This meant we were pretty defensively positioned heading into the pandemic volatility and that really helped.
Conversely, in November, when ‘risk-on’ came swiftly back into play, more cyclical stock such as banks and mining created some opportunities.
Creating a cyclical buffer
This is not because we think these companies are going to grow on a secular basis over the next three to five years. But given their previous valuations and the environment, it may be prudent to allocate to them to protect performance.
However, we do see a big difference between the oil & gas sector and the mining sector. Some of the miners have very sustainable trends supporting their business – not least the move towards EVs, with rechargeable batteries requiring a lot of commodities to function.
Other businesses we are paying attention to are those very likely to be the biggest beneficiaries of the UK opening up from Covid-19 restrictions. The Office for Budgetary Responsibility estimated that the public has stashed away around £180bn in savings, which amounts to around 10 per cent of GDP. So there is an ability to spend, coupled with a lot of pent up demand.
We see opportunities in the home improvements sector, as the housing market is going strong – helped in part by the stamp duty holiday. Particular parts of the domestic travel sector could also see demand increase – the companies who own the coffee shops and restaurants in train stations, and those powering the technology for travellers to book tickets.
It would be remiss not to mention inflation as a factor, not only of goods but potentially services too. There are certain parts of the UK economy which have been heavily staffed by migrant workers from the EU in the past and if we see a shortage of people for those jobs as the economy starts to buzz again then we could see some wage inflation filtering through to the bottom line of some businesses. This is an indicator we will be paying close attention to.
Where to from here?
Overall we expect the rally in the UK market to persist as levels of economic growth and fears of inflation remain high. These conditions favour the UK market given its underlying earnings profile. In addition, the UK market is particularly cheap in a global equities context and this combined with it being relatively under owned given the past impact of Brexit sets it up favourably to garner further investor flows.
Jonathan Rawicz is a portfolio manager at EFG Asset Management. The views expressed above are his own and should not be taken as investment advice.