UK interest rates and inflation are likely to rise faster than the broader market expects, according to JOHCM’s James Lowen and Clive Beagles (pictured), who believe that economic fundamentals are stronger than many people believe them to be. 
As such, the managers – who head up the £3.3bn JOHCM UK Equity Income fund – are retaining conviction in the banking sector, despite the fact many investors are flocking to quality growth over cyclical and value plays.
While many industry commentators believe rising levels of inflation in the UK have temporarily been sparked by the post-EU referendum plummet of sterling, Lowen and Beagles feel inflation will be a more permanent fixture within the economy.
“The oil price is moving up – that’s something we think will play into inflation picking up as we go into next year,” Lowen said. “We have talked for a long time about monetary policy being abnormally low and we’re going to begin to see that adjust.”
Performance of sterling vs US dollar since EU referendum
Source: FE Analytics
The managers pointed out that, over the course of economic history, the world currently has the smallest ever number of countries undergoing recession.
Aside from this, they said there are several indicators to suggest economies across the globe are strengthening, with China’s PPI data suggesting the country is exporting inflation while the eurozone’s confidence measures have reached all-time highs.
“It is no surprise in this environment that we’re thinking about monetary policy change, but uncertainty means this hasn’t yet translated itself into stronger wage inflation,” Beagles explained. “We know that the UK and the US have both experienced very low unemployment but a relative lack of wage inflation.
“We know that there are structural issues here – whether it’s technology, demographics or people working longer, which means they tend to be less productive and get paid less for doing a job similar to someone younger than them – but it is a very significant dynamic in the UK.”
One of the significant contributors to the productivity slowdown within the home market, according to Lowen and Beagles, is the reduction in migration levels into the UK.
They said this is likely to be the result of immigrants feeling less welcome in the UK following the EU referendum, combined with the weakness in sterling and the currency translation effect this will have on transferring earnings to other countries.
“We suspect the number of EU-born workers employed in the UK will probably turn negative in the third quarter – we haven’t had that data yet and it takes quite a while to come out,” Lowen said.
“But if you like, that open tap of new labour supply has definitively been turned off. We’ve been talking to companies and particularly domestically-orientated companies about this issue a lot; many of them are reporting more and more labour shortages and difficulties in getting hold of staff.
“You combine that with an environment in which government austerity is fading. You’ve seen the commitment to raise public sector pay next year. We do think this wage inflation in the UK will pick up and this is why they’re putting interest rates up in the UK.”
The managers argue that interest rates will rise in the UK regardless of the headline inflation number as they believe this is driven by currency depreciation, which is already working its way through the system.
Instead, they reasoned that wage inflation will be a more permanent change to the macroeconomic backdrop and, as such, they would not be surprised to see interest rates rise once again during Q1 next year.
“This clearly brings us to [the prospect] of central banks taking the punch bowl away,” Lowen continued. “It has taken us 10 years to get to here since the financial crisis but finally it’s happening and I think it’s very healthy that it’s happening.
“In the UK, we have wage growth acceleration and, clearly in Europe, they have begun the process of tapering. Time will tell how quickly they do that but we wouldn’t be surprised if they do that a little more quickly than the market assumes.”
Given this, Lowen and Beagles said there will be “huge implications” for market leadership. As the 30-year bull market in bonds draws to a close, they said the likes of consumer staples will struggle and certain cyclical sectors – such as financials – will benefit.
Performance of indices over 10yrs
Source: FE Analytics
This is reflected in JOHCM UK Equity Income’s portfolio, which currently has a 10 per cent overweight to financials relative to the broader market at 36 per cent and a 25 per cent underweight to what they deem to be ‘bond proxies’, such as consumer staples, utilities and pharma.
“In terms of our financials weighting, you can see it’s still the main bedrock of the fund,” Beagles continued.
“The key pillar of that at just under half is the banking sector which will clearly benefit, if what we believe about bond yields and interest rates is right and if that feeds through into the equity markets.
“Also in the banking sector, we will focus on this normalised earnings and dividend agenda as some of those legacy issues fall away.”
Over five years, JOHCM UK Equity Income has returned 83.69 per cent compared to its average peer and benchmark’s respective gains of 67.41 and 62.46 per cent respectively.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
It has a clean ongoing charge of 0.8 per cent and yields 4.29 per cent.