The case for equities is still strong, argues Cavendish Asset Management’s Paul Mumford.
So far this year, a first-time investor could understandably be worried about their exposure to equities. First came US market volatility, sending prices tumbling only to recover and more in a matter of hours.
Now, the Bank of England has warned that interest rates will return to normal “sooner and faster” than predicted. After the gains of 2017, it might be understandable for an investor to consider stepping back a bit.
However, this would be a mistake. While conditions from 2017 are shifting, the case for equities is just as strong and the opportunities as numerous; it’s simply about being smart about where they move to – and how best to exploit them – in an uncertain environment.
First, the coming rate rises herald a long-anticipated return to reality. Although they are expected over the medium term, the long period of low rates means that as firms adjust, it may cause some pain. The Bank of England will need to be careful about the timing and pace so as not to squeeze the economy excessively. Whatever happens, rate rises will inevitably hit companies with high levels of borrowing, creating a headwind where previously there was a tailwind. Individuals with debt and mortgages will also be hit, which could affect consumer confidence.
Back in black
However, presuming the Bank of England doesn’t completely mess up the pace and timing, there will also be positives for investors to exploit. It’s no secret that many companies are facing large pension deficits – even a small increase in rates could provide relief here through fund revaluation, perhaps even putting funds back
in the black.
But rising rates don’t just affect equities. They also negatively impact bond valuations, potentially putting investors off long-term securities where the yield is still low. Given fixed income is already fairly unattractive relative to equities in the current conditions, this could exacerbate the ‘nowhere else for money to go’ factor, boosting equities.
Connected with this is the ongoing sterling saga. Since the referendum, its fall has proved a boon to companies with overseas earnings and exporters. However, it has since picked up against the dollar and rate rises could drive it higher still. As Britain’s future relationship with Europe becomes clearer, we could see sterling regain ground against the euro too.
While this would be damaging for the aforementioned companies, it could provide a lift to domestic stocks and importers. In the retail sector, food and other perishables importers would be immediately boosted, and then clothing and so
on as seasonal orders roll over. This could happen gradually rather than quickly – investors will need to keep a close eye on the balance and be ready to switch strategies accordingly if sterling begins to rise.
As for the remarkable volatility we’ve seen, there are two things worth mentioning. Firstly, it represents more of a sharp correction to certain exuberantly-priced US stocks, rather than any weakness in the underlying fundamentals, so we’re very far from a 2007 scenario. It may have been a one-off, although we may well see heightened volatility for some time with a number of similar corrections along the way.
The latter would have big implications for strategy. Volatility provides tremendous opportunities for an active manager with a stockpicking approach. A nimble manager able to quickly dip in and out – taking profit at the top and picking up shares on the cheap during the corrections – can significantly improve returns compared to passive funds, or an active fund in a calmer environment.
It also favours the smaller caps; these stocks are relatively unaffected by swings compared to the large caps, and also small cap managers are inherently more nimble and able to quickly move in and out. It also makes diversification crucial; you’re far more likely to get caught out by volatility with your eggs in just a few baskets.
Prime sectors remain
Despite all these potential shifts, there are some themes and opportunities which remain largely unchanged. Take oil and gas – especially in the smaller cap end of the sector. For some time now, these companies have been well positioned to reap substantial rewards from even a small rise in the oil price. With crude heading upwards over the long-term, it looks as though these opportunities are crystallising.
A price above $60 a barrel represents a big windfall for many firms, and if it returns to $70+ levels, many will be in super-profit territory. But even if the price falls below $60, many of these companies have put robust hedges in place to protect themselves. Almost regardless of what happens in the overall environment – save for a cataclysmic fall in the oil price – this sector will be a prime one for investors to consider in 2018.
Paul Mumford is a fund manager at Cavendish Asset Management