There are signs the UK economy is slowing and sterling is unlikely to rally from here, according to Neptune’s Mark Martin, who believes any disappointment in the impending general election could cause a currency correction and dampen investor sentiment.
This, combined with the uncertain path for Brexit and the high valuations of UK-facing stocks, means he remains cautious on domestic cyclicals. Instead, he is seeing the best opportunities for his among internationally-facing mid-caps, many of which haven’t yet benefitted from the weakness of sterling.
“There is a strong expectation that the Conservatives will secure a big majority in a general election that is now only six weeks away, which will put the prime minister in a stronger position during Brexit negotiations,” Martin explained.
“Sterling has strengthened significantly as a result and domestic cyclicals have rallied in the immediate aftermath of Theresa May’s shock announcement, while more internationally-facing companies have broadly underperformed.
“The more domestically-focused FTSE 250 has significantly outperformed the FTSE 100 since the announcement, and is now ahead by more than seven percentage points in 2017. More recently within the FTSE 250, companies with a domestic focus have outperformed those that derive their earnings from overseas.”
Performance of indices in 2017
Source: FE Analytics
The manager of the five crown-rated Neptune UK Mid Cap fund says this was initially sparked by the result of last year’s EU referendum, which caused investors to flock en masse into global-facing large-caps at the expense of companies further down the cap spectrum.
However, this trend has started to reverse over recent months as expectations for inflation, interest rates hikes and a rise in global growth have bolstered investor sentiment.
While Martin agrees with the belief that the UK economy is in good shape, he doesn’t think sterling is likely to strengthen significantly from here and is still apprehensive about exposing too much of his portfolio to domestic-facing cyclicals.
“With expectations for a Conservative landslide so high, any disappointment could result in a sterling correction,” he warned.
“Indeed, even if the Conservatives do secure a big election win, the path for Brexit remains extremely uncertain. The only way we see sterling strengthening significantly from here is if the prime minister is able to maintain the UK’s position in the single market.
“This seems highly unlikely given the hard-line stance of EU leaders, who have repeatedly emphasised that they will not allow the UK to have freedom of trade without consenting to the free movement of labour.”
The manager also says there are signs that the UK economy is slowing, despite widespread investor bullishness on the country’s macro backdrop.
In an article published last month, in fact, Lazard’s Alan Custis told FE Trustnet that the backdrop for UK equities looks positive despite the recent pull-back in the market’s growth/value rotation.
“There is a real bifurcation in the market at the moment,” he said. “Some days the miners go up and the next day the miners go down, Unilever goes up and Unilever goes down: it’s on-off almost on a daily basis. I don’t know what is going to break the log jam.”
However, Martin is less positive on the economic backdrop for the UK. He says that, not only was May’s timing in calling the election shrewd from a political perspective, it was also shrewd from an economic perspective.
“Real wage growth has been positive for some time, but the most recent data point showed a slight decline,” he said. “With inflation expectations increasing, negative real wage growth could have a knock-on effect on GDP growth and consumer confidence.
“Recent data showed that UK retail sales recorded their largest decline in seven years in Q1 2017 whilst house price rises, particularly in central London, have also started to slow.”
The manager therefore prefers global-facing mid-caps, many of which he says are yet to benefit from the post-Brexit plummet in sterling. As such, he has used the aftermath of May’s announcement to top up some positions in global-facing companies and remains optimistic they will be able to generate attractive returns over the long term.
Performance of currency vs US dollar over 1yr
Source: FE Analytics
Examples of the largest individual weightings in Neptune UK Mid Cap include media company ITE Group, which organises trade exhibitions and conferences in 18 emerging market countries, and Devro, which is a world market leader in the manufacturing of sausage casings.
“Conversely, we are generally cautious about domestic cyclicals, not only because of the potential slowdown in the UK economy, but because many of these companies are expensive relative to history,” Martin said.
“This includes the housebuilders, which we continue to avoid in the portfolio. We are finding select opportunities however, and have recently initiated a position in specialist lender Aldermore, which is currently trading on just eight times next year’s earnings and valued at only slightly above its book value.”
Over five years, the £584m Neptune UK Mid Cap fund has achieved a top-decile total return of 122.18 per cent, outperforming its sector average and FTSE 250 (ex IT) benchmark by 58.8 and 25.32 percentage points respectively. It has done so with a top-decile Sharpe ratio, which measures risk-adjusted returns, as well as a top-decile downside risk ratio, which predicts susceptibility to lose money during falling markets.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
Neptune UK Mid Cap has a clean ongoing charges figure of 0.82 per cent and yields 1.73 per cent.