In 2017, stocks with higher domestic exposure continued to underperform their international peers, in aggregate. This trend, which began in 2016, has been driven by a drop in sterling and the weakness of UK consumer spending, which has been hit by negative real wage growth.
With the Santa rally having been more than wiped out and many domestic stocks continuing to remain on low valuations, Katen Patel—portfolio manager for the JPMorgan Mid Cap Investment Trust—asks if it’s time to revisit those areas of the mid cap market that are most sensitive to domestic growth?
Weak consumer and higher input costs
The current UK consumer outlook is supported by a strong labour market, with unemployment at multi decade lows. However, wage growth remains elusive and consumer confidence is still very much in the doldrums. Some market commentators expect inflationary headwinds to reduce from here, which could turn wage growth positive, but the outlook for UK monetary policy remains incredibly uncertain and will likely remain that way as we head through the Brexit process.
The possibility of another general election further clouds the picture. The market has started to price in a higher probability of two interest rate increases this year, potentially putting further pressure on the UK consumer, although we should keep in mind that rates will remain significantly lower relative to history.
The sterling rally of 5% at the start of the year is helpful for companies whose cost base is partly in dollars, which includes many of the retailers. However, a lot of these companies hedge their currency requirements a number of months out, so they won’t see the benefit for some time. Meanwhile, they will continue to suffer from higher factory gate costs caused by sterling’s weakness over the last 18 months or so. This can either be passed on to consumers where the power of the brand and product is strong enough (for example, JD Sports or Fevertree)1, otherwise it can result in squeezed margins and potential profit warnings.
Profit warnings hit retailers
As highlighted in a recent article on The UK Edge by one of my colleagues (Timothy Lewis – Your stylish guide to UK markets), a recent2 Ernst & Young report on profit warnings noted that in the FTSE industrial sector (which has higher international exposure) profit warnings are at their lowest for six years, whereas in the domestically-focused general retailers sector, profit warnings are at their highest since the financial crisis. In the last few months alone we have seen profit warnings from the likes of Card Factory, Dixons Carphone and Debenhams1. It now also appears that the new owners of Homebase are suffering losses.
This all suggests to me that many of these domestic companies are cheap for a good reason: namely, the earnings element of the price-to-earnings ratio cannot be relied upon. I am, therefore, still mindful of increasing exposure to companies that are dependent on a strong UK economy given the uncertain outlook and continue to favour stocks with exposure to the global economy, where the picture remains much more rosy.
Selectivity is key
Fortunately, there is a plethora of both international earners and domestic earners within the FTSE 250 Index. As active managers, we can be selective in terms of what we own in the portfolio. Therefore, the Mid Cap Investment Trust is currently overweight international earners compared to the benchmark, although we do have selective domestic exposure in sectors that we feel have structural growth drivers supporting them, such as the UK housebuilders and the UK challenger banks.
In recent weeks we have seen strong trading statements from a number of our large internationally exposed names, such as Electrocomponents, Fenner, FDM and SSP. This portfolio positioning was put in place immediately after the Europe referendum result and has benefitted performance significantly since, with a total fund return of 63%, compared to the benchmark return of 37% to the end of January 2018 (Bloomberg data from 27 June 2016 to 28 February 2018)3.
Most importantly for investors, although there is undoubtedly volatility coming through, the mid cap universe offers investment opportunities whatever the economic and market backdrop.
Katen Patel is a portfolio manager for the JPMorgan Mid-Cap Investment Trust plc. Read more >
Unless otherwise stated, all data is sourced from Bloomberg as at 15 February 2018. Past performance is not a guide to the future and you may not get back the full amount invested.
1The companies above are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell. 2Q4 2017. 3The trust is an actively managed portfolio. Holdings, sector weights, allocations and leverage, as applicable, are subject to change at the discretion of the investment manager without notice.
JPMorgan Mid Cap Investment Trust plc
Investment Objective: Aims to achieve capital growth from investing in medium sized UK listed companies, by outperformance of the FTSE Mid 250 Index. The company will predominantly invest in quoted companies from the FTSE Mid 250 Index, although, where appropriate, it may invest in quoted UK companies outside of this index as well as companies quoted on the Alternative Investment Market which is the London Stock Exchange market for smaller, growing companies. The company has the ability to use borrowing to gear the portfolio within the range of 5% net cash to 25% geared in normal market conditions. Risks: External factors may cause an entire asset class to decline in value. Prices and values of all shares or all bonds could decline at the same time, or fluctuate in response to the performance of individual companies and general market conditions. This trust may utilise gearing (borrowing) which will exaggerate market movements both up and down. This trust invests in smaller companies which may increase its risk profile. The share price may trade at a discount to the Net Asset Value of the company. The single market in which the Trust primarily invests, in this case the UK, may be subject to particular political and economic risks and, as a result, the trust may be more volatile than more broadly diversified trusts. Companies listed on AIM tend to be smaller and early stage companies and may carry greater risks than an investment in a company with a full listing on the London Stock Exchange.