UK equities: weathering the storm ahead

Impact of cost of living increases on UK equity investors

Amid rising energy prices, inflation and interest rates, the impact on consumers of increases in the cost of living is well reported.

But what is the influence on UK equities and investors of the asset class?

With pressure on disposable incomes, Alex Game, co-manager of the Unicorn UK Growth fund, cites reducing demand for consumer-orientated businesses in particular.

Almost nine in 10 adults (87 per cent) reported an increase in their cost of living in March, according to the Office for National Statistics. And the scale of the increase means many consumer-facing companies are likely to see profits fall in the coming months, predicts Emma Mogford, manager of the Premier Miton Monthly Income fund.

But some investment managers say that rising inflation could also encourage workers to increase their productivity and businesses to invest in productivity amid labour shortages and rising wages.

Automation

While the monetary policy committee has been raising bank rate in increments of 0.25 percentage points to influence inflation, Thomas Moore, manager of the Abrdn Equity Income Trust, highlights how the Bank of England is clear that its monetary policy will not affect commodity prices or supply chain bottlenecks.

“They are focused on the labour market," he says. "They do not want wage expectations spiralling.

"Over time, rising labour costs might encourage employers to shift from labour to capital equipment, automating processes. This would increase productivity, but it will take time.”

Richard Marwood, a senior fund manager at Royal London Asset Management, also cites more automation as a potential solution in an inflationary environment, which would enable businesses to run with fewer staff, or increase the availability of staff to work on value-add activities such as innovation or improving customer service.

Laura Foll, a portfolio manager at Janus Henderson Investors, says the message she is hearing from companies is that rising input costs – particularly wages alongside labour shortages in some industries – are pushing them to make capital expenditure decisions that they otherwise would not have.

“An example of this would be the food industry, where there are well-publicised labour shortages, and in some cases even if companies have put up wages materially they are struggling to hire enough staff. This has been a sector which in the past has, in some areas, struggled to automate," Foll adds.

“But with labour costs going up while the costs of robotics are coming down, the relative economics have shifted. At an economy-wide level, if more businesses make this kind of decision, this should have a positive effect on UK productivity in the years to come.”

In the meantime, Moore says UK equity investors need to be selective about which stocks and sectors they own. “This inflationary environment is a boon to some sectors, such as mining, oil and gas, raising the prospect of a super-cycle following years of under-investment.”

UK productivity has always been seen as a concern, lagging many other economies, says Ninety One portfolio manager Matt Evans.

But on a positive note, he adds that a tougher economic environment, driven by rising inflation, may lead to improved productivity as workers step up to ensure they can cover rises in the cost of living.

Laurence Hulse, co-manager of the LF Gresham House UK Smaller Companies fund, agrees that rising inflation and living costs are likely to make consumers more conscious of their expenses and earnings, and how they can improve the latter: “One answer to this is increasing their productivity to command greater leverage with their employer or improve performance-related pay.”

Low unemployment and rising living costs imply higher economic activity by employers and employees, Hulse adds, with current statistics implying almost full employment.

He says: “From here, output per hour likely improves, whatever happens next.

"Either employers resort to the only alternative to increased hires, which is incentivising and innovating to create higher productivity among existing resources; or the labour market does actually peak here and start to cool, in which case, employees may have to compete harder to retain roles.”

Did the local elections affect UK equities?

The cost of living is reported to have had an impact on local voters as well as investors.

When asked about what would be ‘very important’ to them when deciding who to vote for in local elections, the cost of living was the most common issue cited by Britons in a survey from Ipsos.

Foll says in previous years she would have been wary of putting much emphasis on the outcome of local elections, which usually have a lower turnout when compared to general elections.

But this year she says they have been significant because they have been a barometer for the current Conservative government and, most importantly, the leadership of that government.

Of the parties, the Conservatives saw the biggest defeat, with the loss of 11 local authorities in this year’s local elections, while Labour gained six councils and the Liberal Democrats five.

Prior to the elections, Foll had said if the elections pointed to a “decisive swing” away from the Conservatives, it could lead to a period of greater political uncertainty.

She adds: “What I think is key from a UK equity market perspective though is the context in which this is happening. Sentiment towards UK equities remains poor, as demonstrated by ongoing net outflows, and UK equities continue to trade at a valuation discount to overseas markets such as the US.

“Sterling has also been notably weak versus the US dollar in recent months. Therefore UK equities are starting from a point where it could be argued that they are already pricing in a degree of discount for political uncertainty.”

Hulse says: “We can and should be comparing this year’s results to history and exploring what this may tell us about the next general election, which can and usually does drive domestic themes and fiscal policy changes.

“The results certainly imply a heightened chance of change at the next general election because they tell us the incumbent party has clearly lost ground. Whether this just catalyses changes in policy by the current government now or leads to a change to a Labour government is unclear, but investors will be revisiting lots of longer-term assumptions after the results.”

GDP

A rising gross domestic product (GDP) environment will also be important for any future productivity gains beyond the post-Covid trend, says Hulse.

“It will underpin the confidence for business to invest in driving additional long-term productivity gains," he adds.

Monthly GDP was 1.2 per cent above its pre-coronavirus pandemic level, according to the ONS’ estimate for March. GDP fell by 0.1 per cent in March, after a revised figure of no growth in February.

Simon Murphy, manager of the VT Tyndall Real Income fund, is also optimistic, saying he is generally “less bearish than most” due to factors that offset and lessen the impact of the rising cost of living.

“These include a healthy employment market with plenty of job vacancies and good rates of wage growth, a robust housing market and consumer and corporate balance sheets that are in sound shape, given all the support provided by the government through the pandemic.”

Abrdn’s head of UK equities, Andrew Millington, agrees that the local election results have little impact on the UK equity market.

Instead, he cites the impact of inflation on consumers and businesses, and the risk of a recession next year, as the current key driver of UK domestic stocks.

Despite being positive on productivity, Hulse at Gresham House likewise thinks it will form "only part of the picture for UK equities at most".

He adds: "The much bigger narrative driver is going to be inflation itself, which I think is going to get worse before it gets better.

"Combined with another likely significant energy price cap increase in October, this looks set to overshadow productivity changes."

Inflation is likely to keep rising to around 10 per cent this year, before falling next year, according to the BoE.

Inflation winners

Energy-intensive industries that are located in the UK have already scaled back production, says Mark Swain, manager of the Enterprise fund at Sanlam Investments, which is likely to continue for as long as energy prices remain high.

And while businesses with pricing power will ultimately pass on rising input costs to consumers, Swain notes that not all businesses can do so, where margins will be eroded by higher input and commodity costs.

But he adds that consideration should be given to the fact that energy and materials sectors, which benefit from high energy and commodity prices, account for almost a quarter (22.95 per cent) of the MSCI UK Index, which measures the performance of the large and mid-cap segments of the UK market.

Banks are also set to benefit from rising interest rates as the spread between mortgage and deposit rates grows, says Abrdn's Moore.

“The main risk is that inflation eventually causes demand destruction and bad debts, as consumers collapse under the weight of rising living costs,” Moore adds.

Resilient businesses with price inelasticity, or that offer non-discretionary goods and services, will be key for equity investors, says Hulse.

“We look for businesses with above-average margins and experienced management teams that generate cash with low debt levels.

"With the Gresham House UK Smaller Companies fund, we have intentionally exited cyclical or consumer discretionary names.”

Millington at Abrdn likewise says the key for UK equity investors will be deciphering, ahead of time, which companies will profit warn as the year progresses, and which companies will be able to navigate the economic environment above market expectations.

chloe.cheung@ft.com