Stuart Taylor outlines why 2023 could be a very good year for UK stock market returns and how the LF Canlife UK Equity Income fund has the potential to benefit from this thesis.
To the contrarian investor, the level of negativity in the media combined with the low valuation of selected parts of the UK market is a strong signal to buy. There are reasons to believe the UK economy and consumer are not looking over the edge of as deep a precipice as commonly believed. If that proves to be true, there are very attractive returns on offer.
Inflation
Inflation has been a hot topic for many months and is causing pain across all cohorts of the population, but there are reasons to believe it will reduce over the course of 2023. Commodity prices have historically loosely led inflation, but following very strong commodity prices earlier in 2022, many are now significantly below their high points, and this should be a downward influence on inflation.
Source: Bloomberg, ONS
More directly, petrol and diesel prices are also well below their high points. Although they are currently higher than 12 months ago, if they remain at current levels, by the end of H1 2023 they will be down around 20% and 13% year on year respectively, with the price of oil down 30%.
Source: Bloomberg
It’s a similar story with gas and electricity prices that feed into the Ofgem energy price cap. Even though this has temporarily been superseded by the government price guarantee, it’s going to lower the cost for them, perhaps creating some fiscal breathing space.
Source: ICIS ESGM
Source: Ofgem
The cost of shipping goods around the world has also collapsed to pre-pandemic levels and the recovery in sterling from its low point is also a benefit to UK importers.
Source: Bloomberg
Labour Markets
In the private sector, average weekly earnings growth has been reasonably robust, with public sector pay dragging down the headline figures. With the current news filled with stories of strike action across a range of sectors, from nurses to driving test examiners, the pressure on wages probably remains upwards. There may also be upward pressure on employers who failed to help their employees last year. It’s therefore plausible, if far from certain, that by the end of the year real wage growth could be heading into positive territory.
Source: ONS
Mortgage Rates
Mortgage rates have been increasing since the second half of 2021 but rapidly accelerated upwards during Kwasi Kwarteng’s brief but memorable stint as Chancellor. The move in bond yields and swap rates, which are the basis for fixed rate mortgages, was unprecedented. Since the appointment of Jeremy Hunt and Rishi Sunak as Prime Minister and Chancellor respectively, some calm is being restored to the markets and swap rates have fallen, albeit to higher levels than we have seen since the Great Financial Crisis.
If current swap rates persist, it is likely that fixed rates for mortgages will follow, as banks use up the funding they had secured at higher rates and pass lower rates onto customers. The spread between swap rates and the rate offered to customers is also somewhat higher than before the pandemic, so there is also scope for that to reduce and ease the pain for borrowers a bit more.
Source: Bloomberg, Bank of England
Source: Bloomberg, Bank of England
In addition to fixed rates hopefully easing during the year, there is evidence that the government and banks are working together to ease the cost-of-living pressures of the UK population, in stark contrast to the banks being the cause of the problem in 2008/09.
In June 2022 the FCA wrote to the banks, setting out how it expects the banks to support vulnerable customers through the cost-of-living crisis. In December, following a meeting between the Chancellor and most UK bank CEOs, the FCA gave more detailed guidance outlining what forbearance measures they expect to be on offer to customers experiencing difficulties.
These include:
- Interest rate switches without an affordability assessment
- Mortgage term extensions
- Variations to interest only mortgages
- The offer of prospective forbearance to customers who could reasonably expect to experience payment difficulties even if they have not yet missed a payment.
Separately, on 20th December, the Treasury announced an extension of the Mortgage Guarantee Scheme until the end of 2023.
Coincidentally, perhaps, concerns in some quarters about the resumption of bankers’ bonus caps and a ceiling on reserve remuneration have come to nothing and the government is talking about the need for a strong and internationally competitive banking sector. It seems as though a deal has been done.
Bond yields
The increase in bond yields during 2022 caused a dramatic re-evaluation in the equity markets as overvalued growth and ‘high quality’ stocks devalued from, in some cases, ridiculous levels whilst more lowly-rated companies fared much better. The UK Equity Income fund was positioned to benefit from this trend and it did so during 2022. The question is: “what happens next?”
There are several competing forces acting on UK gilt yields:
- Inflation: as discussed above, we expect it to reduce sharply but persist above the target rate of 2% as real wages catch up. How the bond markets will react is difficult to predict.
- The Bank of England’s (BoE) Asset Purchase Facility (APF), which has been a very large buyer of UK government bonds through its QE scheme, is now being wound down.
- The BoE is still increasing interest rates, but how much further they will go is uncertain.
On one hand, as inflation falls the real yield on UK gilts will naturally rise compared to the nominal. All else being equal, this will increase the attractiveness of the of gilts and reduce upward pressure on nominal yields.
On the other hand, the BoE is unlikely to be buying gilts. Such a large buyer potentially turning to a seller would increase upward pressure on nominal yields.
Additionally, the BoE increasing base rates places upwards pressure on the yield curve as a whole. On the other hand, its intention is to bring down inflation, placing downward pressure on yields.
Source: Bloomberg
Source: Bloomberg, BoE
It is possible that, rather than being an active seller of gilts, the BoE just lets its stock expire over time. This will reduce upward pressure, but the fact remains that a large buyer is out of the UK gilts market.
Source: BoE
In conclusion, our view of the direction of bond yields is with lower conviction than it was at the end of 2021.
Areas of Opportunity
Banks
UK banks have had mixed fortunes but the large, listed players such as Lloyds and Barclays trade at large discounts to their book value and are now able to make sustainable returns in excess of their cost of capital. Therefore, we could reasonably expect them to rerate significantly this year as they prove their resilience. They are already well provisioned for a difficult economy and have plenty of surplus capital should they need it.
Retailers
The retail sector has already reacted to a deep UK recession, with many stocks down well over 30%. There is a wide divergence of quality and financial resilience in the retail sector but there are some very attractive opportunities in high-quality companies with robust balance sheets and cash flow. Whatever the next few months hold in store, the large, listed retailers seem certain to come through it. As those of us with long enough memories have seen before, the stock market is very likely to rerate the shares before this happens.
Insurance
Rising bond yields have had a profound effect on the condition of UK defined benefit schemes, effectively wiping out the vast majority of scheme deficits. These corporate schemes are now in a condition where they can be passed on to an insurance company and removed, finally, from the desks of UK finance directors.
Source: Pension Protection Fund
It is estimated that only around 10% of UK liabilities have been de-risked via an insurance transaction and it is suggested that there could be £650bn of liabilities transacted over the next decade. This is a structurally growing market, with high barriers to entry where the participants have ample capital to employ at good returns, and trade at elevated valuations.
Summary
This note makes a case for a positive outlook and highlights the opportunities. There are clearly risks but they are plain to see every time we open a newspaper or turn on the TV news. Therefore, they are probably more than reflected in share prices and this provides the opportunity. The fund’s benchmark began 2022 on a PE ratio of 13.4x and ended it on 10.0x, which is a significant change - and many good-quality companies within it suffered much worse.
As always, we will aim to manage the fund pragmatically, being led by the data, within the risk framework investors expect. However, we will also be looking to exploit a recovery in the UK market.
| Discrete Performance to 31 December 2022 | 1y to 31/12/22 | 1y to 31/12/21 | 1y to 31/12/20 | 1y to 31/12/19 | 1y to 31/12/18 |
| LF Canlife UK Equity Income Fund (C Acc) | 6.74 | 16.83 | -12.85 | 19.28 | -10.31 |
| Bloomberg UK Large and Mid Cap TR GBP | 1.17 | 18.61 | -11.42 | 18.55 | -9.44 |
Source: Morningstar, bid to bid, with income re-invested for C share class as at 31/12/2022
Important Information
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate.
Due to the underlying assets held, the price of the fund is classed as having above average to high volatility.
The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
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