The UK equity market is somewhat in limbo at the moment as investors await the outcome of the general election, writes Guy Stephens, who takes a look at the potential shift in favour from growth to value investments.
This market limbo is typical of pre-election period, but we may see some volatility throughout the campaigns. We hope that voters are given a reasonable period of time in order for the important policies to be flushed out.
The markets are understandably in limbo, suppressed from direction, as a hung parliament is a distinct possibility with all parties saying they will not do any coalition deals with anyone. The value of sterling is probably the best barometer as to what the markets think is going to happen.
We have to take an investment view regardless of our own political views - what matters is what the majority of the people are likely to vote for, not what the members of our various investment committees think. In the pursuit of opportunities, it is imperative that an investor is able to forecast the future economic environment accurately.
Most importantly, this involves foreseeing a slowdown coming and taking risk off the table and the opposite, observing a benign and supportive business environment where risk taking will be rewarded. It is the latter that has prevailed over the last few years and there have been excess returns available in new technology businesses.
However, since the summer, their winning streak has come to an end with so-called growth stocks selling off. Basically, Wall Street said ‘enough' after disappointment following the flotation of taxi businesses Uber and Lyft and started applying far more scrutiny to IPOs.
Growth to value shift
As the likelihood of a no-deal Brexit has reduced, which has fuelled the sterling rise, bombed-out sectors that would have been most vulnerable, such as housebuilders, construction and commercial property, have enjoyed a recovery. This has led to many commentators suggesting that investors should be seriously considering a switch from growth investments into value and that this could be the beginning of a trend following an inflection point in September and October. It is important not to confuse what is going on in the US technology space and what is happening in the UK with all the political influences.
The UK equity market currently appears to believe that the Tories are going to achieve a workable majority and consequently ‘Get Brexit Done' as is the party slogan. While that outcome would most likely be achieved in the Commons with regard to passing the withdrawal agreement, all this means is that we then have just over a year, probably less with Christmas in the way, to agree a new trade agreement with the EU. This was always supposed to be the most difficult part and where the horse-trading and potential for disagreement was going to arise.
We would argue that buying so-called ‘value' stocks which have just rallied sharply in October as their worst-case scenario has been avoided for now, is not a sensible longer-term strategy. Many of the so-called opportunities are priced cheaply for reasons of structural long-term decline and have not been overlooked as the market has focused on growth and technology.
They are actually value traps for the foreseeable future and there is a high likelihood that the end of the transition period will have to be extended and we return to the 'Brexit limbo dance' after the 'election limbo dance'.
As ever, the definition of value is based on the investor's opinion of the quality of the underlying business and what the share price should really be. A business in secular decline should be priced at a discount to the average market valuation and similarly a business with a dominant position and a bright future at the forefront of technological innovation should be priced at a premium.
Growth businesses tend to do well in economic slowdowns and during the early and mid-phase of an economic expansion. They tend to get sold-off when doubts about the economic expansion come to the fore and their premium valuation then looks too expensive based on the deteriorating outlook.
As investors take risk off the table, these stocks get sold early to lock in profits. We would argue that phase has happened, while the world economy looks like it is stabilising. So, it is too late to sell, but there is likely to be further growth ahead as economic expansion resumes.
As for value stocks, they tend to be the weakest during an economic slowdown, but they experience a bounce when the outlook improves because they have survived the downturn revealing they are stronger than perhaps the market thought and are therefore due a re-rating.
Fundamentally, however, they are most likely still a challenged business with a weak business model and unless they are in a unique turnaround situation or there is a negative sector influence that is about to change in a significant way, it is usually sensible to still be sceptical and possibly sell into the bounce if you have been unfortunate enough to hold the loss-making position.
In conclusion, therefore, we would continue to stick with quality growth businesses going forward as we foresee an improved economic environment both globally, in the US and, shall we say, a less gloomy outlook in the UK with some Brexit certainty if the polls and currency markets are proved right.
Guy Stephens is technical investment director at Rowan Dartington
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