Consumers hold the key to UK recovery

  • UK economic growth depends on consumers spending their post-pandemic savings
  • BOE may nudge up rates from near zero but not significantly
  • China economic ramifications will resonate globally
  • Energy transition and energy prices in focus

Richard Buxton, head of UK Alpha Strategy, discusses the macro-economic backdrop and whether consumers will continue to spend, spend, spend their pandemic savings despite the bite of higher taxes and energy costs.

Whilst prospects for the UK consumer are always key to the outlook for the UK economy, this is particularly the case for 2022, as the immediate surge in activity driven by emerging from lockdown fades. A strong labour market, with over one million job vacancies currently, is underpinning some wage growth alongside an easing in public sector wage restraint. Unfortunately, the combination of migrant labour having left the UK and a seemingly Covid-induced reduction in older workers remaining in the workforce suggests many of those vacancies may remain unfilled.

Forced savings during lockdown mean that household balance sheets are swollen, as confirmed by significant excess deposits at UK banks. Much will rest on the degree to which consumers draw down on these savings to spend next year, if growth in jobs is more limited. Offsetting the labour market strength, higher utility and energy prices together with the increase in National Insurance taxes next April will squeeze incomes, particularly for the lower paid. Given that these workers tend to have little or no savings, the economy may need the better off to dip into their savings, although this will hardly address income inequality, which may well worsen next year.

If consumers choose not to run down their savings or rebuild credit card debts, it may be that expectations of another very strong year of economic growth post-pandemic are too optimistic. Whilst Government spending is clearly set to rise, excluding emergency measures such as furlough, companies facing higher National Insurance contributions on their employees – and materially higher corporate tax rates in 2023 – may well think twice about hiring additional workers. No wonder the Bank of England has cautioned that whilst interest rates will nudge up from near zero, it has no current intention of raising them significantly. The outlook is just too uncertain.

Two other issues may attract a lot of focus next year. Already it has become clear that the climate change agenda has led to sharply lower levels of investment in fossil fuels, even though the world will rely on them for many years yet during the energy transition. Ambitions to wean the planet off fossil fuels have not gone unnoticed by OPEC plus Russia, who are now incentivised to maximise revenues during the coming years by restricting supply. Reliance on erratic wind and solar power in the absence of sufficient gas storage – or a breakthrough in electricity storage – has already led to surging gas prices recently. Cold winters may become an annual challenge for national grids, with high energy prices a dampener on economic activity.

China has increased its reliance on coal-fired power as a result, and in a significant change in policy is contemplating mass closures of energy-intensive industries. Equally, it appears to want to deflate gently its real estate market. Even for a state-managed economy, that looks like a tall order, with key ramifications globally if it were to go wrong.

Oscillation and opportunity in the UK smaller company stocks

  • Valuations in the UK small & mid cap space are comparable to those across Europe, with significant valuation polarisation
  • It makes sense to combine exposure to growth businesses at valuations we can rationalise with holdings in cheaper and more economically sensitive businesses
  • This is an environment to try to add value through good stock selection

Dan Nickols, Co-Head of Strategy for UK Small & Mid Caps, says it makes sense to focus on adding value with good stock selection given the range of possible market and economic outcomes.

Given the lingering effect of the pandemic and the potential for future waves to weigh on economic recovery and growth, we are mindful that we continue to live in unprecedented times and that, whatever our central case for the path of UK economic growth may be, we must accept that the range of possible outcomes is wide.

That said, it feels wrong to be unduly pessimistic about UK economic prospects. The UK labour market remains strong, with low levels of unemployment, decent wage growth and over one million unfilled job vacancies. Inflation is making for higher living costs which have a disproportionate effect at the lower end of the income demographic, but the UK consumer in aggregate continues to sit on significant excess savings as a legacy of government intervention during the pandemic and curtailed spending opportunities in the recent past. While the supply side of the economy remains affected by shortages of labour and goods, demand should remain strong.  
Economic backdrop
More effective government?
More effective government would be helpful – thus far, no tangible net economic benefits from Brexit are visible and promises to level up investment around the UK have been walked back.

Valuations in aggregate in the UK small & mid cap space are comparable to those across Europe but there is significant valuation polarisation, making it difficult to argue for any further upwards revaluation of already expensively rated growth stocks, or those that grow earnings/sales faster than the market average. Within UK small & mid caps, thematic leadership has been oscillating for much of ’21, following the early year rally of value stocks, or those that trade at a price lower than their intrinsic value.

Small caps are companies with smaller stock market values or capitalisations; mid caps are medium sized companies that sit between small and large caps. Large caps are companies with a large market capitalisation, generally the bigger companies within a given market. Definitions based on market cap value can vary.

Uncertain pace of recovery
We can expect this oscillation to continue given the interplay of uncertainty around the precise pace of economic recovery and the path of monetary policy normalisation.

For this reason, we think it makes sense to combine exposure to growth businesses at valuations we can rationalise, with holdings in cheaper and more overtly economically sensitive businesses that will see earnings delivery underpinned by ongoing economic recovery and self-help, and where we think there is an opportunity for rerating, or upward revaluation of a stock. This feels like an environment where it is right to try to add value through good stock selection rather than by introducing aggressive thematic tilts to portfolios.

Keeping the right balance in UK mid caps

  • Our strategy is to be reasonably balanced with a tilt toward structural growth
  • Costs rose for ecommerce companies just as lockdowns eased and more people were shopping physically
  • We might have another six months for inflation to run in the best scenario

Richard Watts, Co-Head of Strategy for UK Small & Mid Caps, explains why he’s optimistic about the outlook for midsized companies and at the same time keeping a close eye on inflation.

I’m positive about the opportunities next year in UK mid cap stocks because I think the demand backdrop will continue to be strong. Disposable income is very high, job growth is strong, and wages are growing. People will continue to spend the money they saved during the lockdown.

Economic growth is good here in the UK and elsewhere around the world. The focus on how markets are going to perform really comes down to inflation. It will prove to be either stickier or more durable than people expect, which might be a bad thing for equity markets, or it might prove to be more transitory though still a longer transition.

We might have another six months for inflation to run in the best scenario. If inflation turns out to be transitory that would be very constructive. You would have relatively strong demand, inflation under control and monetary policy and bond yields not rising as much as people had expected – very supportive conditions for stocks.

In UK midcaps, some faster growing companies, including e-commerce companies that did well in 2020 struggled in 2021. Ecommerce has felt the white heat of the supply chain disruption. Longer delivery times has meant it’s been slower to get product into warehouses and to customers. That impacts sales because people don’t buy as much if they must wait longer for delivery.

Costs rose for ecommerce companies just as lockdowns eased and more people were shopping physically in stores. Their organic growth was impacted as they were up against tough comparisons to 2020 the lockdown when everyone shopped online.
The SMID opportunity set
I would describe our strategy as being reasonably balanced with a tilt toward structural growth, i.e., faster growing companies. Fundamentally, the mid cap index — mid-size companies — are mostly fast-growing businesses. They offer that growth dynamic. These businesses have a longer and faster growth runway than most other companies that we can find, and for many, their valuations are too low right now.

Our strategy includes owning domestic cyclicals companies, whose earnings tend to be connected to the economic cycle and do businesses mostly in the UK; we also have global cyclical companies, including equipment rental companies that are active in the UK and US. We also own housebuilders, as well as airlines, which should benefit from a recovery in travel next year.

The market for initial public offerings of stocks is good, having slowed somewhat since the start of the year. The market for unlisted companies has been active and fundraising activity has been strong.

The value of active minds: independent thinking