The market is behaving in an “extreme and dangerous way” and investors need to be wary of paying over the top valuations, according to FE Alpha Manager Neil Woodford.
While there are opportunities in the market, speaking at the AJ Bell investment conference last week, the fund manager said investors taking broad exposure could be in a dangerous position as only specific stocks and sectors have been run up to high valuations.
As a result, some of the more unloved areas of the UK market have almost been through a bear market, he explained.
The manager of the five FE Crown-rated, £8.7bn CF Woodford Equity Income fund has come under pressure in recent months as performance of the fund has lagged.
Indeed, the fund lost 4.26 per cent over the last six months and, while it has eked into positive territory (0.88 per cent) year-to-date, it remains one of the worst performers in the IA UK Equity Income sector this year.
Performance of fund vs sector and benchmark over YTD
Source: FE Analytics
“We have had a very difficult 12 months from a relative performance point of view due, I would say, to different performance-based factors at the early part of 2016,” Woodford said.
“What is happening is the market is now [doing] almost all of the things I don’t agree with. I think markets are behaving in a pretty extreme and dangerous way.
“There are all sorts of coincident measures of market madness and some are flashing red to me right now and have been flashing red for a period of time.”
The manager said while there is a lot of risk in the market, investors appear to be comfortable taking on these additional risks – a phenomenon that has not worked out too well in the past.
“At the moment there is a lot of risks in things that investors now feel very comfortable about – consensus positions in the market seem to be appropriated with very little risk,” he said.
At the same time, while some sectors have been bid up recently due to a number of factors, others have been completely left alone.
“Equally the things that the market has run away from in the last 18 months seem to me to be where the opportunity set is,” Woodford said.
“This bifurcated market is characterised by loved index stocks and sectors that have got to very high levels. Valuations are very stretched in my view and the fundamentals are nowhere near supportive and are actually deteriorating.
“But away from that you have almost had a bear market where parts of the market have been in a really bad way for some time and valuations are very low,” he added.
“It is a really odd environment and not unlike, in some ways, other extreme periods of recent stock market history.”
As the below shows, over the last fiveyears the MSCI United Kingdom Growth index has outperformed the MSCI United Kingdom Value index by 15.23 percentage points.
Performance of indices over 2yrs
Source: FE Analytics
Within this however there has been much wider stock and sector dispersion as investors feared the effect that the Brexit vote may have on the economy.
One of the biggest moves was sterling, which has depreciated 11.27 per cent against the US dollar since the vote.
As such, companies with overseas earnings have been sought by investors while importers and more domestically-focused stocks have been sold off.
Performance of sterling vs US dollar since EU referendum
Source: FE Analytics
“I think the currency issue is not the main driver but it is symptomatic of what I have talked about,” Woodford said.
“There is a broad consensual view of investing in the UK that the UK is a basket case and certainly UK economic exposure is something that no international investors wants at the moment. So they are running away from that.
“When the currency is weak that reinforces that desire to move away from UK assets to the extent that if international investors are owning UK assets they are owning ones that are popular, are exposed to international earnings and the China growth story.”
Woodford said investors have an “obsession” with buying mining stocks and “proxy mining stocks” that have more overseas earnings, such as HSBC (up 77.65 per cent since the Brexit vote) and Diageo (up 46.32 per cent).
“This currency move that we’ve seen means that theme has played out in the market and is symptomatic of this dangerous and one dimensional view of the world that investors seem to have huddled around,” he said.
However, Woodford said that the UK economy, which has fared much better than many analysts predicted, looks set to continue to perform ahead of expectations.
“There are all sorts of things that drive the economy to be better than expected and Mark Carney raised interest rates by 25 basis points the other day because he felt able to do so, because the UK economy has been better than he thought when he cut them,” the manager said.
“The outlook next year is for the UK economy to grow more quickly than it has in calendar '17.”
One reason for this is the high number of people employed, with 400,000 more people in work than at the time of the EU referendum. That figure could grow with 1.2 million unemployed people eligible for work and 800,000 jobs currently being advertised.
This has led to higher wage growth, particularly in the lower income households, with the introduction of the national living wage benefiting many of the lowest earners.
“The fact is the real wage pressure in the UK has actually occurred in lower income deciles. People by the way who have a higher propensity to spend have seen good real wage growth in this period since UK voted to leave the EU,” Woodford said.
“So people in the UK on lower incomes have enjoyed good real wage growth over the last 12 months and it was no surprise to me that those cohorts who have a higher propensity to spend have continued to spend.
“It is not just because they have more disposal income, which they have – their incomes have gone up and also the amount of tax they pay has gone down.”
As such consumer spending, a key driver for why the UK economy has held up better than expected, is expected to remain buoyant.
“You could see how more people in work over the next 12 months will drive a slightly better consensus outcome for the UK economy,” he noted.
While this wage growth is a positive, he noted that it is unlikely to keep inflation high, as many people fear.
“Why have we got higher inflation than the rest of the world – because of Brexit and because of what happened to the currency,” the manager said.
Indeed, the last inflation figure grew to 3 per cent, but Woodford said this has now peaked – something that should benefit the UK economy.
“I think we will get better real wage growth next year, because inflation will come down, but it is not going to scare higher growth,” he added.
As such, in an upcoming article FE Trustnet will look at why the manager is backing UK banks to recover given the positive outlook for the UK economy.