Stephen Message is loading up on banks in his L&G UK Equity Income fund in anticipation of a ‘soft’ Brexit, saying he cannot see the UK crashing out of the EU without striking some sort of deal.
Following some immediate turmoil, the FTSE rallied after the UK voted to leave the EU in June 2016, with the fall in the pound acting as a tailwind for the large multi-nationals that derive most of their earnings from abroad.
Performance of index since 23 June 2016
Source: FE Analytics
Domestically focused sectors went the opposite way due to fears of a recession in the UK, with some stocks seeing intra-day losses of up to 30 per cent – and many of these areas have continued to struggle since then on fears about the impact of a hard Brexit
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However, despite the current chaotic situation in UK politics, with prime minister Theresa May struggling to agree Brexit terms with her own party, let alone the EU, Message (pictured) has built up a meaningful overweight in domestically focused companies. The manager said this is “clearly based on the assumption that we don’t crash out without a deal”, adding that the rising tension between various factions is little more than posturing.
“I think MPs at the moment are starting to see and starting to grapple with all the things that Theresa May has been grappling with for the past two and a half years,” he explained.
“It wouldn’t be a proper negotiation if all interested parties on various sides were not very vocal in what they wanted and that’s got to play out. So the risk to my view is that we crash out without a deal, but I don’t think that is going to happen.”
The starting point of Message’s process is valuation, with the manager meeting company directors and analysts, carrying out site visits and conducting his own bottom-up modelling to get a sense of what is priced into shares and what could make them re-rate.
However, while he is a bottom-up stockpicker, he also takes into account certain macroeconomic factors, which is what led him to go so overweight financials – the sector currently makes up 34 per cent of the fund with Lloyds and Barclays top-10 holdings.
“A lot of it is tied into the direction of interest rates and bond yields,” said the manager, “and if the market continues to price out the event of a no-deal, then it will also have to reappraise its outlook for the direction of interest rates.
“Broadly at the moment I think one interest-rate rise is priced in. But in an environment where ‘no deal’ is taken off the table, then I think bond markets might start to focus on maybe two rate rises and maybe even three over time, because actually if you look at the underlying picture of the domestic economy, UK wage inflation is running north of 3 per cent, there are record levels of employment and the job market is tight.
“I’m pretty sure members of the MPC [the Bank of England’s Monetary Policy Committee] will look at this and think inflation pressure is actually starting to build a bit. And in that environment where the market starts to reappraise its outlook for the interest rate environment, then I think market leadership will shift more towards financials. That supports the likes of Barclays and Lloyds.”
Of course, Brexit-related uncertainty is not the only reason why bank share prices are depressed, with Message noting the sector is the only one not to have staged a meaningful recovery from the financial crisis. Data from FE Analytics shows Lloyds is down more than 40 per cent since its 2007 peak, while RBS is down 95.45 per cent.
Performance of equities since financial crisis
Source: FE Analytics
However, Message said he can now see light at the end of the tunnel, and although it feels like “two steps forward, one and a half steps back”, the sector is definitely moving in the right direction.
“We’re getting there,” he continued. “Legacy issues such as fines for misconduct are now becoming legacy issues, we will get through that. The banks are much better capitalised and they have been delivering for a number of years.
“The missing ingredient now would be a return to a more normal interest rate environment, which would pave the way I believe for rising dividends. The banking sector has historically been a much larger meaningful contributor to the market’s dividends.”
The flipside to Message’s hunch on Brexit – that the pound rises on the back of a deal being agreed with the EU – is that the multi-nationals which make most of their sales overseas could take a sudden hit from currency movements. He believes bond proxy multi-nationals in particular could face a double-hit in such a scenario as a subsequent rise in interest rates would make them less appealing to investors as fixed income and cash generate higher levels of income once more.
One area he is particularly worried about from that point of view is fast-moving consumer goods companies.
“For example, I don’t own Unilever or Diageo,” he said. “They are great companies, but they are already enjoying strong profit margins and younger market participants often forget they haven’t been in an environment where the trends that have driven these stocks [since the financial crisis] haven’t been prevalent.
“The process here, remember, is always trying to find companies where margins are depressed or currently out of favour. I get very nervous with areas that feel in favour and have been performing well.”
Data from FE Analytics shows L&G UK Equity Income is down by 8.55 per cent since Message took charge of the fund in October 2017, compared with losses of 4.19 per cent from the IA UK Equity Income sector and 2.05 per cent from the FTSE All Share.
Performance of fund vs sector and index under manager tenure
Source: FE Analytics
However, the manager has outperformed over the course of his career, making 84.2 per cent since he started running money in November 2009 compared with gains of 78.25 per cent from his peer group composite.
L&G UK Equity Income is yielding 5 per cent. Someone who invested £10,000 in the fund five years ago would have received £2,088.06 in income alone since then.
The £215.8m fund has ongoing charges of 0.78 per cent.