While the British love a good doomsday story, the outlook for both the UK economy and the market look relatively positive, according to FE Alpha Manager Leigh Himsworth.
The manager of the four crown-rated Fidelity UK Opportunities fund warned that there are risks out there but at a surface level the UK looks constructive for investors.
Despite a number of issues including the UK’s decision to leave the EU in last June’s referendum and the recent general election result, the market has remained strong over the last two years, as the below shows.
Performance of index over 2yrs
Source: FE Analytics
Indeed, over the last two years the FTSE All Share has gained 19.28 per cent but Himsworth noted that investors have recently been drawn in by gloomy rhetoric despite the strong performance.
“Lots of people in the UK market naturally, being British, love a horrible tale,” the manager said.
“If you come out and say ‘the end of the world is just around the corner and we are all going to die suddenly, et cetera’ the British love it.
“It is far easier to sell a negative story than it is to turn around and say that actually things are okay in the UK both in terms of the economy and the market, which are very different beasts.
“The outlook for the markets is actually fairly attractive. I hate to say fantastic because there are always risks, but it is not super negative like some people out there are saying.”
The main reason for Himsworth’s optimism is that the economy has finally gone back to normal for the first time since the financial crisis in 2008.
“What happened in the financial crisis is that we had massive special measures, with interest rates kept very low and quantitative easing brought in,” he explained.
In theory, when interest rates rise, people are less willing to borrow money because it is more expensive meaning that there is less money in the economy. Meanwhile. the reverse is true if interest rates are reduced as the cost of borrowing is much cheaper.
“The problem was we reduced money as much as we could and in theory that should have provided a huge boost but it didn’t because the banks didn’t want to lend as they wanted to repair their balance sheets and the consumers also wanted to repair their own balance sheets,” he added.
As such, the UK has experienced a prolonged period where, even though money has been very cheap, no one wanted to lend or borrow.
However, he said this has changed in the last 12 months, with the banks now willing to lend money again after cleaning up their balance sheets. 
“All of a sudden the bank is happy to lend again and you can see also that consumer borrowing is picking up significantly from a negative period for a number of years,” Himsworth (pictured) added.
“The importance is when the banking system is working properly again you get a multiplier effect back in the economy.”
This has fed through to the ‘real economy’, which is now “functioning properly again rather than this unusual period,” the manager noted.
“That means we can see some inflation come back into the economy which is good for the economy,” he added.
Performance of RPI over 5yrs
Source: Office for National Statistics
“When we talk about inflation people say it is not there but they are really talking about the print last month because when we look at it, CPI [consumer price index] is running ahead of the Bank of England target and RPI [retail price index] is well ahead as we’re at the top end of the 3 per cent mark.”
He noted the recent phenomenon of ‘shrinkflation’, with chocolate bars such as Toblerone becoming smaller rather than amending prices as an example that inflation is in the system – albeit in a sometimes unusual fashion.
Yet, he said people are “hanging their hat” on the idea that this inflation is not sustainable because it has yet to feed into wage growth.
“With unemployment sub-5 per cent you would think wage inflation would see more pressure but there is still inflation there – it is in the realms of 2 per cent and that is inflation to me,” the manager said.
This has come in pockets rather than nationwide, with the national living wage boosting some of the lowest earners. But thoughts of scrapping the public sector pay increase cap could also boost wage inflation sooner than many expect.
So with inflation coming back in the system and a banking system working properly again, Himsworth said this creates investment and interest in the economy.
If this is correct, then bond yields are at the wrong price, with UK 10-year gilt yields currently around 1.2 per cent.
“The point is are bond yields at 1 per cent the right price? If they are then it means we have some deflation coming. It means RPI running at 3.5 per cent really shouldn’t be there it should be -0.5 per cent at least but that is really not the case,” he said.
As such, it means the vast amount of money currently invested in bonds needs to be moved for a better returns, with equities “probably the right place to be”, according to the manager.
“So when you look at the UK market, you’re expected return for equities is around 10 or 11 per cent,” he said, referencing median earnings growth figure of 8.7 per cent and a dividend yield of 3.2 per cent.
However, investors should ignore the ‘bond proxies’ which have been on an incredible run in recent years as investors have prioritised income in the low yielding environment.
“People have been looking for an income return anywhere as if you can’t get it in bonds you need to get it in the so-called ‘bond proxy’ stocks,” Himsworth said.
“But if we think bond yields are gradually going to go up and there is no longer that massive hunt for income in stocks, and if we’ve got some growth coming through in the market then that rush for simply income is no longer as essential as it might have been four or five years ago,” he added.
“So, all of a sudden, we can see some underlying change in the market because we don’t need the bond proxies instead we can try and find the returns from growth companies and those that are sensitive to rising interest rates and inflation.”
He said that the situation has been confused significantly in the early part of this year by the potential bid for Unilever.
“That has made the space look a lot more attractive than it has been but if you look on a year’s basis a lot of those bond proxy stocks have struggled in relative terms,” he explained.
“Gradually people will come round to the fact that you can get growth elsewhere in the market and you can get your returns elsewhere as well.
Himsworth runs the £110m Fidelity UK Opportunities fund, which has been a top quartile performer over one, three and five years, though it has slipped to the third quartile over the year-to-date.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
“A lot of it comes back to if you look at what’s happened with UK bond yields this year: in the early part of this year people just wanted safety,” the manager noted.
“That’s not really where I’ve been at all so that has been difficult but more recently as people have started to focus back on economic numbers, things have changed a little bit and the bond yield has flipped up.
“In our portfolio we need to start thinking about moving away from some of those bond proxy type stocks and shift the focus to those that succeed in some inflation/growth environments and that means moving towards financials companies and moving down to the mid- and small-caps.”
In upcoming articles, FE Trustnet will look at the companies the manager is using for short-term inflation and interest rate movements as well as his longer-term themes.