Beware the cyclical basket case
In the wake of sustained high inflation, rising interest rates and a weakening economic outlook, equity markets are increasingly pricing in the risk of recession. In some cyclical UK stocks, valuations are now starting to approach levels last seen in the Great Financial Crisis. Matthew Tillett and Richard Knight, portfolio managers of the UK Listed Opportunities strategy explore to what extent this is an accurate reflection of potential turbulence to come.
Key takeaways
- UK equities are increasingly priced for recession, as a result of sustained high inflation, rising rates and weaker economic data
- In some more cyclical sectors, valuations are reaching levels last seen in the Great Financial Crisis
- However, in areas like travel, companies are still benefitting from the effects of economic reopening post pandemic
- Equally, some housebuilders and specialist lenders may be less cyclical than the market is currently pricing
- Seizing these opportunities does not require a strong view on the likelihood, length or depth of a recession, but instead a clear focus on long-term intrinsic value in the face of distressed prices
Equity markets are increasingly pricing in the risk of recession. Sustained high inflation, rising interest rates and a weakening economic outlook are bringing down earnings expectations across the board, particularly in sectors with a high degree of exposure to consumer spending. Even the UK market, which this year has benefited from low starting valuations and a substantial weighting to commodity producers, as well as defensive sectors such as pharmaceuticals and consumer staples, has given up some of its gains in recent months.
In some cyclical stocks, valuations are now starting to approach levels last seen in the Great Financial Crisis. The question is whether this represents an opportunity or instead is an accurate reflection of the turbulence to come?
Our value-driven approach is centred around the analysis of single stocks and, as such, we try to avoid making top-down calls on the economy. Moreover, as stock pickers, our allocations to sectors and segments of the economy are a by-product of our conviction in individual investment cases. However, we believe that the wholesale nature of these cyclical devaluations is creating specific opportunities with a number of themes in common.
The travel and leisure sector was one of the hardest hit during the pandemic. International lockdowns, combined with a fear of infection and the additional cost of testing/potential quarantine meant that between April 2020 and March 2022, air passenger arrivals to the UK were on average, 79% lower than levels seen in the year prior to the COVID-19 outbreak1. Domestic travel similarly collapsed, with passenger rail journeys falling 78% in the financial year ending 20212.
With the approval of Covid-19 vaccines, shares in travel companies rallied significantly. However, the slower-than-expected pace at which volumes have recovered, combined with recent rising fuel costs and higher wage bills, has left the sector as a whole under a new cloud, with many shares trading at close to their pandemic lows. We believe this meaningfully overstates the potential for disruption, while overlooking the pent-up demand from consumers as life post-Covid continues to normalise.
This is particularly the case with Jet2, a holding in the UK Opportunities fund. The shares are only slightly up on the pandemic lows, despite being in a very different place. Since the onset of Covid-19, Jet2 has gained substantial market share, in part due to its high levels of customer service, as well as large competitors that have had to retrench or even gone out of business entirely. The company’s strong balance sheet - especially compared to competitors - means Jet2 has been able to invest ahead of the recovery in its end markets. As a result, over the coming years Jet2 expects to grow into a much larger business than it was prior to the pandemic.
Conversely, housing was one of the pandemic’s largest beneficiaries. With the majority of us spending almost all of our time at home, UK demand for housing that was both larger and further away from city centres increased markedly. According to the building society Nationwide, which monitors house prices, the average price of a UK home has risen by almost £50,000 since the start of the pandemic in March 2020. Even as of April 2022, the Nationwide house price index was recording growth of 12.1% year on year3.
Yet the potential for a recession has seen valuations in housebuilders slide into near freefall. At the time of writing, shares in Redrow – a specialist in building larger homes – were trading well below net asset value with a net cash balance sheet. This discount assumes a sharp and sustained drop in profitability for an industry which – due to a fundamental lack of supply – has often proven to be more robust than expected. Indeed, according to recent research from RBC, “of the seven UK recessions since 1968, only one has led to a house price correction [greater than] 10%, two have led to house price corrections of [less than] 10% and four have actually led to an increase in house prices”4. At the same time, Redrow benefits from the fact it targets higher net worth customers who are less sensitive to the cost of living.
The performance of Financials stocks in 2022 has been a mixed bag. At the start of the year, expectations for rising rates boosted those names with exposure to net interest margins. In the UK, these tend to be highly commoditised banks with substantial consumer lending in the shape of mortgages, such as NatWest. Until late 2020, we had never owned this type of bank in the portfolio, owing to their low-quality business model, limited growth runway and relatively full valuation. However, having examined the sector closely in 2019 and assured ourselves of the security of their balance sheets, we took the opportunity to initiate a number of positions in the wake of the pandemic. Valuations at this point effectively assumed a replay of the Great Financial Crisis, despite the sector having significantly improved at a fundamental level.
As the prospect of higher rates boosted shares in these more commoditised financial names, we took the opportunity to crystallise some profit. In turn, expectations of weaker economic conditions have brought down valuations in more specialist lenders such as Close Brothers. The company has a long history of operating in very attractive niches – for example asset finance for small businesses – which allow for consistently high returns on capital, and steady long-term growth. Unlike many banks, the business weathered the Global Financial Crisis very well, showing the advantages of a contrarian approach to capital allocation as well as the strengths of the underlying asset base.
It is important to reiterate at this point that these are not top-down views on any particular sector or economy. Instead, these are bottom-up fundamental views on individual stocks, linked by excess downward macro and sentiment driven pressure on valuations. Currently, this pressure is coming in the form of excessive fear around the impact of an inflation-driven recession relative to each stock’s long-term intrinsic value. Such mispricing lies at the heart of our investment philosophy. After a decade characterised by “easy” money and multiple expansion, these mispricings are becoming only more relevant in the search for alpha.
1. Source: https://www.gov.uk/government/statistics/statistics-relating-to-passenger-arrivals-since-the-covid-19-outbreak-may-2022/statistics-relating-to-passenger-arrivals-in-the-united-kingdom-since-the-covid-19-outbreak-may-2022
2. Source: https://dataportal.orr.gov.uk/popular-statistics/how-many-people-use-the-railway/
3. Source: https://www.nationwidehousepriceindex.co.uk/reports/house-prices-post-tenth-successive-monthly-increase-in-may-to-keep-annual-price-growth-in-double-digits
4. Source: RBC Research Paper, UK Banks: Death by a thousand cuts; Benjamin Toms – July 4, 2022