There’s a simple way to dodge UK political storms

 

Predictably, British politicians think they can defy financial markets — one solution is to buy global

Simon Edelsten

This article was originally published in the Financial Times

During my career, both of the UK’s main political parties have been beaten up by markets.

Labour had to be bailed out by the IMF in the debt crisis of the 1970s. In 1992, the Conservatives let a few hedge funds shove sterling out of the European currency system on Black Wednesday.

Labour was in power in the run-up to the global financial crisis of 2008. And then there was Mr Kwarteng’s disastrous mini-Budget. So that makes the score two-all.

People talk about “bond vigilantes”, anthropomorphising the bond market and making it sound like a gang of City mafia dons plotting evil. It’s much simpler than that. If you lend money to someone for 10, 20 or 30 years and your confidence in their ability to repay diminishes, you’re going to want more reward for your risk, no matter which political party they represent.

UK gilts have been falling since the start of the Iran war, reflecting the rising cost of energy. They have now sunk further due to the political risk of the Labour Party lurching left and spending willy-nilly under new leadership. The problem with making unfunded spending commitments is that the final bill can be much bigger than you expect. When bond investors price in fiscal incontinence, it lifts the cost of all subsequent debt issuance.

In the old days, UK politicians were less “in hock” to the bond market. Not today. The UK plans to issue more than £250bn of gilts this year — four times what it did before QE and the pandemic.

The cost of servicing our £2.9tn gilt pile is set largely by international investors today. They have another option beyond demanding more — they can just take their money elsewhere. If they do, that could weaken sterling, lifting the cost of imports, pushing up inflation and undermining the value of UK equities.

But we can go elsewhere, too. Global equity funds are a quick way to move savings abroad. The cheapest option is to buy a global index fund, and this has been undeniably rewarding for some years.

Do that today, however, and you’re buying into an index with a concentrated array of stocks with fragile valuation support — the technology stocks enjoying the AI boom and particularly semiconductor stocks. These now dominate the global (and US and emerging market) indices.

Semiconductor stocks are famously hard to value during booms, when sales and revenue soar. You have to project the angle of the boom’s ascent and its duration. Will sales double, treble or quintuple? And how long can they stay at elevated levels?

If you’re looking for better valuation support and are comfortable holding a portfolio very different from the index — and I’d suggest you should be — actively managed global funds appeal. Yes, I run one, but when did anyone listen to me?! There are plenty to choose from.

Another option is to look at individual stocks. Companies with solid, but not booming growth stories have performed poorly of late and now trade at the lowest valuations seen for some years.

These shares are usually valued by adding up future cash flows. But interest rates have risen from 0.25 per cent to 3.75 per cent in the past four years. That’s a problem for equities. An uncertain cash profit many years hence is a lot less attractive when cash in the bank is better rewarded, and so the multiples — the years of cash flow — that people are willing to pay can fall.

If you construct a discounted cash flow model for a pretend company that grows its cash earnings at 8 per cent a year — which most would call a good lick — changing the interest rate from 0.25 per cent to 3.75 per cent reduces the equity valuation by around a third (using a 5 per cent equity risk premium, if you were wondering).

Unsurprisingly, many growth stocks that once traded on 30 times current earnings now trade closer to 20 times. That makes them much more attractive than some of those pricey tech/semiconductor stocks, in my view. Two sectors in particular come to mind.

Until recently, scientific equipment makers had a solid history of growth in demand — from academic institutions, drug discovery, diagnostics, environmental and food testing. A slowdown in demand from China and cuts to academic budgets and drug research spending in the US have changed that, but the pendulum will swing.

We own Thermo Fisher, the leading company in the sector. Over the past decade it has grown its revenues 10 per cent compound, but sales haven’t progressed since the pandemic peak. We’re particularly reassured that over half its revenues come from repeat sales of consumables and software needed by its installed base of equipment, so cash profits keep rolling in even during periods of more modest growth.

Then there’s Hollywood. Where, how and what we watch has changed greatly — less real-time television, more short-format online nonsense; less cinema and more streamed binge sessions. Netflix seems well established in our budgets these days, averaging 12.6 per cent annual compound revenue growth over the past five years. YouTube is now estimated to command 14 per cent of UK viewing time. We own Netflix, Disney and Spotify.

I can’t predict what’s coming, but in today’s political storms, shifting money from the UK and from global trackers into a global actively managed fund or individual stocks with more solid valuation support could be wise.

 

This research material is for distribution only to Professional and eligible counterparties as defined by the FCA and also to persons of a kind to whom it may lawfully be promoted by an authorised person by virtue of Section 238(5) of the Financial Services and Markets Act 2000, the Financial Services and Markets Act 2000 (Exemption) Order 2001 and COBS 4.12.4R. and should not be relied upon by any other persons. Therefore circulation of this research material must be restricted accordingly.

This material is provided for information purposes only and does not constitute a solicitation in any jurisdiction in which such solicitation is unlawful or to any person to whom it is unlawful. Moreover, it neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to it by making an offer to enter into an investment agreement. This research material may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition.

Moreover, certain historical performance information, other investment vehicles or composite accounts included in this material and such performance information is presented by way of example only. No representation is made that the performance presented will be achieved, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the time of publication and may change as subsequent conditions vary. The information and opinions contained in this research material are derived from non-proprietary sources deemed by the Firm to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not indicative of future results. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment.

The Investment Manager is authorised and regulated by the Financial Conduct Authority and registered in England and Wales (Company Number: OC304213). Its registered office address is 6 Stratton Street, Mayfair, London W1J 8LD United Kingdom.