The first key to unlocking value in the UK small cap space

Brexit remains an emotive subject politically and over the UK dinner table. It is now very clear that the promises made by the ‘Vote Leave’ campaign were illusory and the rationale for severing ties with Europe for most was political and nostalgic rather than economic. The deal that was eventually ushered in for 2020 reflected no-one’s vision of life after Europe. But, having sat in the departure lounge for the best part of four years, Brexit fatigue had long set in. The UK economy had performed better than expectations in the meantime, though the lack of clarity on the Brexit deal itself had clearly tempered inward investment.

One of the most vociferous opponents of Brexit was Nissan, who had openly cast doubts over its commitment to their Sunderland plant that employs 6,000 people and supports 70,000 jobs in the automotive supply chain. In 2019 we estimated that the hiatus in decision-making had left UK capital investment more than 20% behind trend. It is difficult to draw more meaningful conclusions as the whole picture has since been so heavily distorted by the impact and ripple effects from the pandemic. What we can say is that practicality quickly overrode principle. What really mattered for business was some clarity on the operating and trading framework which would kick start decision-making again. In the last quarter the very same Nissan downplayed the Brexit impact as ‘negligible’ as they announced a £2bn investment programme at Sunderland which would remain the company’s primary European manufacturing hub for the foreseeable future.

If the real economy has moved on, equity markets have not.

UK equity valuations have not recovered from the de-rating that began with Brexit. The beginning of 2020 carried with it the promise the trend would reverse but that prospect was rapidly overtaken by the arrival of the Covid-19 virus. The economy and the stock market were both denied the opportunity to demonstrate their resilience and disprove any number of proclamations of the UK’s demise. The Brexit legacy, as a consequence, is a perception that an apparent lacklustre UK recovery from the pandemic at least in part reflected a Brexit impairment.

The UK economic activity picture painted by reported GDP figures has suggested both that the economic hit from Covid-19 was deeper than peers and that the recovery has lagged peers. It has been very easy to conclude that, at least in part, this economic performance reflects a Brexit impairment. In contrast:

• The UK’s pandemic recession was shallower than reported
• The UK economic recovery has been better than reported

The UK’s pandemic recession was shallower than reported

The calculation of UK GDP includes an estimate for public sector activity known as the UK government consumption deflator. The deflator is a proxy for the increase or decrease in expenditure that is incurred by the government in the delivery of services such as health and education. Ordinarily this is not a material adjustment to the annual calculation of GDP. However, 2020 was clearly not a normal year. The combination of different public policy (time spent in lockdown or the closure of schools) and a more aggressive methodology for calculating public sector activity meant that reported UK GDP assumed a much greater impact from reduced public sector activity. The impact was to reduce reported GDP by an estimated additional 5%.

The UK economic recovery has been better than reported

For much of the post pandemic period the economic recovery of the UK has appeared to lag that of OECD peers and has played to the poor relation of Europe narrative. The reported aggregate picture has not sat comfortably with that painted by many domestic facing publicly listed businesses we regularly interact with, certainly coming into 2023.

The legacy of the pandemic is that the government balance sheet expanded to protect people and jobs while the private balance sheets of both consumers and businesses shrank significantly. A furloughed workforce restricted in spending built cash on deposit to a combined level of nearly 10% of GDP and the population’s credit balance had shrunk to 20 year lows. Pent up demand was meaningful and before the acceleration in inflation and interest rates, while selective, consumer spending on leisure, hospitality, recreational and holiday activities bounced back strongly post pandemic. In fact, more so than originally estimated.

In September 2023, the independent Office for National Statistics (ONS) updated calculations of UK post pandemic activity and revealed that official UK statistics had underestimated UK GDP over 2021 and 2022 by a cumulative 1.85%. Until this point much had been made of the UK being the only major developed economy not to have recovered to pre pandemic levels of economic activity. The revised data placed the UK firmly in the pack of its European counterparts, with a faster recovery than Germany and in line with France and Italy. The news itself is not a market event, but is a challenge to perceptions that have prevailed and been imposed upon the valuations of UK listed companies during that time. The UK recovery from the pandemic was not so lacklustre after all.

Interest rate policy and inflation levels have arguably been the most contentious debate of the last two years for all developed economies. What can we add to this debate in the UK with any confidence?

• Outsized base effects have been at work
• The monetary policy medicine is working
• Clarity on Brexit terms unlocked decision-making in the real economy and financial markets. Clarity on peak interest rates can do the same…

Outsized base effects have been at work

While the sources of inflation have been common and shared internationally, their interaction is felt differently locally and nationally. Amongst the OECD nations this sets national policy makers off on a similar path, but with different consequences. The common starting point is that the damage done to production and supply chains by the pandemic then met greater-than-expected pent up post pandemic demand. On top of this, Russia’s invasion of Ukraine compounded supply chain shortfalls in soft commodities and exacerbated industrial bottlenecks.

The most profound impact though, particularly in Europe and especially the UK, was felt in the escalation of energy costs as access to Russian gas was sanctioned, exposing energy insecurity and more than a decade of energy policy failure. The UK has invested heavily in renewables over the last decade. When the sun shines or the wind blows the marginal cost of energy rapidly approaches zero. However, in the absence of extensive gas and electricity storage solutions the closure of the last coal fired power station left the UK with a depleted reserve margin and a heightened vulnerability of spot pricing to any restriction on global supply or extreme winter weather demand. Add to this a decade of flawed energy competition policy which artificially depressed the prices UK consumers and businesses paid for electricity and the UK was vulnerable to a double whammy from a global supply side energy shock. For the purposes of understanding the evolution of UK inflation in the last two years the most important element is the impact of that artificially low base effect when inflation takes hold and was ultimately reflected in peak inflation prints at 11%, well north of OECD peers. In tandem with the misrepresentation of UK economic activity in the official GDP statistics it has been very easy to look at those elevated inflation numbers and reach a UK stagflation conclusion. It is also just as easy to conclude that there are structural flaws in the UK economy to explain the UK’s seemingly worse experience of both.

The truth is in fact far simpler. The peak in the price of energy in the UK, adjusted for policy support, was July 2022 and is now creating a very large base effect from which quite quickly it becomes difficult for UK inflation not to fall, even allowing for wage inflation. The question is how quickly, informed not only by global energy prices but better preparedness for winter requirements and the crowding out of demand such an extreme move carries, even before we get to the impact of monetary policy. Inflation expectations, and with them two-year treasury rates, peaked in July 2023, since when UK inflation figures have rapidly rejoined the pack of global peers. The latest UK inflation print of +4.6% YoY is the lowest for two years and the fourth print in a row that has proved better than expected, either in headline rate or mix. Accordingly, after 14 consecutive interest rate rises, in September 2023 the Bank of England surprised markets by holding interest rates constant for the first time since December 2021.

The monetary policy medicine is working

The emerging economic data suggests that the monetary medicine is working in the UK. UK two-year treasury yields peaked at 5.5% in July 2023 and began to decouple from the US as UK inflation expectations fell against a US ‘higher for longer’ narrative. UK two-year treasury yields were trading at a 50bps premium to their US equivalent in July. Just quietly, in the second half of 2023 UK two-year yields have come in 120bps and are now trading at a discount to their US equivalents.

In the US, circa 70% of the mortgage market is on a 30-year fix. The insulation provided by longer term fixes goes some way to explaining the greater resilience of the US consumer and the growing acceptance until very recently of the ‘higher for longer’ narrative.

In the UK, 70% of the mortgage market is also fixed, a dramatic improvement from 30% a decade ago. However, those fixes are typically over two to five years and cannot provide the same insulation from the rising cost of borrowing. Interest rate rises have had a real impact on discretionary income as mortgages are refinanced, or on consumer confidence where that refinance is anticipated. As we approach the end of 2023 the UK mortgage refinance cycle process is more than 50% complete.

The Bank of England committee has begun to speak openly to the lag effects of interest rate rises and ‘increasing signs of some impact of tighter monetary policy on the labour market and on momentum in the real economy more generally’. While the policy makers are unlikely to get carried away, falling inflation and interest rate expectations are already being reflected in improving mortgage rates and lower future costs of borrowing for corporates.

There is of course a conversation yet to conclude as to where inflation and interest rates settle, of which wage inflation is a factor and is yet to fully play out. However, as the UK economy slows the balance between demand and supply of labour has improved. Unfilled vacancies which peaked north of one million have begun to shrink, not just because of employment decisions put on hold, but because availability has begun to improve. The ‘needs must’ of a rising cost of living environment is coaxing back many who reappraised their work life balance in the immediate aftermath of the pandemic.

Clarity on Brexit terms unlocked decision making in the real economy and financial markets. Clarity on peak interest rates can do the same…

In some respects, we see parallels in the inflation and interest rate cycle with the conclusion of the Brexit deal at the beginning of 2020. As we approached the end of 2019, it was increasingly apparent that for decision-making in the real economy and UK equity markets to unlock all that was required was clarity on the trading framework with Europe. It mattered less or little whether it was a good, bad or indifferent framework. Comprehension of the new normal was sufficient for businesses to plan and investors to allocate capital. The same could be said of inflation and interest rates today. The clarity that businesses and investors require is not necessarily an accurate read on the cost of capital, simply that decisions made today won’t be embarrassed by significantly higher inflation or interest rates tomorrow. The UK looks increasingly like the first of the developed economies to have reached that juncture.

Since the Brexit referendum in 2016 the pantomime of British politics has offered little to reassure that safe hands are at the UK government tiller.

In just seven years we have had one referendum, four new Prime Ministers, two general elections, a gilts crisis, Partygate and Jeremy Corbyn. But, the grown ups are now back in charge, the next general election promises not to be a market event and amongst OECD peers UK public finances today carry the lowest vulnerability to any perceived political risk.

Act I: The referendum

The Brexit referendum itself was an attempt by David Cameron to silence or contain the Eurosceptic wing of the Conservative Party. Instead the referendum proved a triumph of political rhyme over economic reason. The political, financial and economic freedoms from severing EU ties were emotively and knowingly oversold to voters. The debate quickly polarised and left a divisive political climate with little prospect of a consensus on what life after Europe should look like. Theresa May went for an early general election in an attempt to secure a majority that would enable her to really define and deliver Brexit. Instead, she was left with no overall majority, trying to negotiate exit terms from Europe with both hands tied behind her back.

Act II: Corbynistas

In the year before the referendum the Labour Party had accidentally elected Jeremy Corbyn as their new leader. Corbyn was a traditional socialist, old school, soap box politician perceived widely as harmless and everyone’s second or third choice candidate. Underestimated inside and outside the Labour Party, Corbyn tapped into an anti-establishment vein. His growing popularity emboldened a Labour Party lurching to the left, raising real concerns of a tax and spend, business unfriendly Labour government.

Act III: The world king

Ever practical, the Conservative Party responded in kind by ditching Theresa May’s pragmatism for Boris Johnson’s infectious if blustering optimism and unashamed pursuit of power. In 2019, Johnson delivered an unexpectedly decisive election victory for the Conservative Party. Johnson is a natural bombastic orator who was able to reach and connect with voters across the political spectrum, disenchanted with or disenfranchised by politics. If the manner of his election victory shared parallels with Trump, so did his premiership... accident and error prone, characterised by a loose relationship with the truth and riding roughshod over the democratic institutions of state. By the summer of 2022 his politics and character were as dishevelled as his appearance. Now an electoral liability - et tu, Brute?

Act IV: Truss(t) is broken

In normal times a government enjoys some flexibility in defining its own fiscal rules. The Truss government ceded that credibility and that authority in September 2022 with a gung ho, ill conceived, poorly communicated and unfunded growth strategy. UK gilts took fright, forcing intervention by the BoE and drawing comparisons of the UK with emerging markets. Truss was quick to throw her new Chancellor Kwasi Kwarteng under the bus. A swift policy reversal followed and the installation of Rishi Sunak as Prime Minister. Truss served less than 50 days in office, a record no Prime Minister wants to hold. The more conservative/realistic strategy demanded by markets, supported by a more prudent balance sheet, was delivered in the 2022 autumn statement. Thankfully, economic credibility with markets was quickly restored.

UK 10-year gilt yields - The Liz Truss impact

Source : Bloomberg

The final act: the grown ups back in charge

The real legacy of Johnson is not delivering Brexit, nor is it pandemic ‘Partygate’. It is the unintended consequences for undiluted extreme left and right wing politics. Johnson delivered an electoral hammer blow to Corbyn, since when the Labour Party under Kier Starmer embarked on reforming its own governance, its relations with the unions and purged its more radical elements. Similarly, in exposing the far right to government, Johnson allowed economic ideology to meet the full force of economic realities resulting in a Truss hari kari. The curtain appears to be coming down on an extended period of political theatre. In its place a new consensus is re-emerging in the middle ground of UK politics. It covers the importance of respect for the processes and conduct of government, fiscal discipline and the trust of markets, and a business-friendly policy and tax framework. That Chancellor Jeremy Hunt and Prime Minister Rishi Sunak have made great strides in these respects post Truss is perhaps no surprise. What might not be appreciated outside the UK is these are views shared by a Labour Party hell bent on reassuring it can be trusted with the economy. The message for business and the City has been refreshingly dull. Should Labour win, don’t expect any policy fireworks. Not least if anything goes awry in the first term they will be able to blame ‘the last lot’. This year’s general election no longer looks like a market event. The performance of sterling and the gilt market indicates political risk premia that has reduced materially, but given valuation levels we would suggest is yet to be extended to equities.

UK public finances carry the lowest vulnerability to any heightened political risk

The UK government has the lowest funding requirement of its OECD peers at 21% of outstanding debt over the next two years. By comparison, the US has 38% of outstanding national debt over the same period. That supply is before accounting for the Federal Reserve’s desire to reduce its own balance sheet. Across Europe, the supply picture is a little better in a range of 29% (France) to 34% (Germany) and 35% (Italy). The longer duration of UK national debt means UK Treasuries suggest better scope to access the international sovereign debt market on improved terms versus peers.

The second insight in this three-part series will explore more favourable technical trends emerging in the UK Small Cap market.