Richard Colwell has no exposure to oil in his £3.9bn Threadneedle UK Equity Income fund, warning that even though it is the best performing sector this year, it is impossible to predict the future direction of the underlying commodity.
The UK market has had a relatively strong year so far as global macroeconomic factors have landed favourably for a number of its largest companies.
Covid-related supply chain disruption has been exacerbated by the war between Russia and Ukraine, leading to a surge in oil and commodity prices.
Oil giants Shell and BP, and mining titans Rio Tinto and Glencore, make up a large part of the UK market. Banks also make up a significant tranche, and these have benefited from another major macro theme this year – rising inflation and interest rates.
The Bank of England has already hiked interest rates to 0.75% from 0.1% in December last year, and is expected to raise them again this afternoon. This makes the banks more profitable as they make their money from the difference in interest they pay to depositors and the interest they earn on loans.
These three sectors (oil, mining and banks) are among the five best-performing sectors in the UK in 2022, as the below chart shows.
However, not all fund managers are convinced these are the best areas to invest in for the long term. Colwell said he “harbours deep reservations over the unforecastable nature of commodity prices”, adding we “don’t feel we have an edge as active managers” in this area.
Taking oil first, the manager said: “Company managers have little visibility of future behaviour – affording investors limited scope to forecast or predict movement of stocks.”
Colwell added that the market can move exceptionally quickly, pointing to 2008 as a recent example. The oil price started the year around $95 per barrel, rising to $150 in the summer before ending at $50.
“Admittedly, it felt painful not owning much oil and miners in the first half of 2008, but we felt much better about it in the second half,” he said.
This time around the fund has nothing invested in oil shares, a significant underweight compared with the benchmark’s 9.5% weighting and an unusual stance compared with his equity income peers, considering Shell and BP are big dividend payers.
The manager said there have been four events in history that look like today – when the Brent spot price has doubled its three-year average.
“Sometimes this marks a peak in prices (1990, 2000), and other times oil keeps rising (1979, 2000),” he said.
This does not always correlate to wider market falls, however. After each event, the US ISM Purchasing Managers Index (PMI) has fallen, which has suggested the economy has moved intro contraction (and potential recession).
Yet while the MSCI World Index fell 30% in the 12 months following the 1974 and 2000 oil peaks, it was up 10% in the 12 months after those in 1979 and 1990.
This time around the US PMI numbers are in rude health, which should help “limit the damage”, Colwell said, suggesting even if the oil price falls, the market may hold up.
Similarly, the manager was unimpressed with the mining sector, despite a relative outperformance of almost 20 percentage points relative to other sectors.
The fund has a 1.9% position in basic materials firms, a 6.5 percentage point underweight to the FTSE All Share index.
“The sector has become overbought,” Colwell said, as investors have clamoured for inflation protection. “While metal markets may offer some short-term protection against inflation, the truth is prices – and therefore demand – are sensitive to the start of a substantial and sustained shift in the US Federal Reserve’s monetary policy,” he added.
Eventually, this should boost the opportunity cost of no-yield commodities versus the rising yields of other US dollar assets. Added to this is China, where demand could dwindle if plans to go green affect areas such as the steel industry.
All this makes the prospect of a commodity “super cycle” unlikely; more probable is a “post-recession reflation trade”, which will “typically last 12 to 18 months”.
One area Colwell is focused on is mergers and acquisitions (M&A), where “the huge valuation arbitrage is continuing to stoke interest from private equity and foreign investors”.
Last year there were 12 transactions in excess of £500m on the UK market – the most since 2007 – and despite the struggles this year, Colwell predicted there will be more of this to come.
“Pearson, for example, received its second and third bids while Russian president Vladimir Putin was waging war. Although ultimately a deal was not agreed, interest has not peaked and UK-quoted assets continue to attract a lot of interest,” he said.
The Threadneedle fund has already benefited from a number of high-profile moves, including for supermarket chain Morrisons, insurer RSA and aerospace firm Cobham.
“The bottom line is that there is still lots of dry powder out there, and we fully expect it will keep targeting the UK equity market,” he said.
“As patient, conviction investors, we will continue to avoid whipsaw momentum trades and concentrate on company fundamentals to target strong, risk-adjuste