UK equities: Why less changed than a brief sell-off implied

In summary...

• A strong run for hedge funds and momentum investors ended with a bang
• The fundamental attractions of UK equities have not changed
• Forecasts for UK economy continue to be revised higher and UK consumers are in rude health

If you were taken by surprise by the strength of the recent recoil in markets, you were not alone.

A couple of weeks ago, markets thought inflation was coming down, a soft landing was on the cards and the US election result in November was a no-brainer. That clarity did not last long.

So, what happened?

• Biden stepped aside and the result of November’s election instantly became less certain.
• Weaker US manufacturing numbers and a decline in payrolls data – perhaps weather-influenced – saw sentiment taking a 180-degree turn. A recession was suddenly viewed as imminent, and the Fed was seen as being ‘behind the curve’.
• Some strategists began calling for an emergency cut from the Fed, with the bond market pricing-in 125bps of cuts in the US by the end of the year – from just 50bps of cuts at the start of July. 

To us, however, the changes in the economic outlook looked comparatively modest. We expect a lot of the handwringing was driven by the need to find a narrative to fit the huge moves in the market. We believe much of the volatility can be explained by investor positioning, market structure – and by the rapid unwinding of a huge carry trade.

Enter the Bank of Japan…

On positioning, it has been a good year for hedge funds and other trend-following investors. Following a handful of simple themes (the AI boom; the world’s ballooning appetite for weight-loss drugs) generated strong performance; low volatility allowed some investors to take on more risk by increasing leverage.

So far, so good. At least until the Bank of Japan caught the market off-guard by raising rates and announcing QT. This brought to an abrupt end one side of a huge carry trade used by trend following hedge funds: to borrow the yen cheaply to invest elsewhere. Much of this money had flown into things such as Bitcoin, weight-loss stocks and the Magnificent Seven, which soared on excitement around AI.

Just as the Bank of Japan was preparing to raise rates, results from the Mag Seven began to suggest that while companies have spent a lot on AI, they have seen little return – so far, at least. This ‘peak AI’ narrative hit the other side of the carry trade. The resulting unwind was spectacular as stop losses were triggered and there was a stampede for the exit.

In a world where there are fewer active investors and a growing crowd of options traders and asset allocators, moves can be sudden and dramatic when the narrative changes. The fact the story changed at a time many market participants were on holiday and trading volumes were thin, further amplified the moves.

A 12.4% fall in the Nikkei in the space of one day demonstrates the market impact when a trend reverses¹. Signals from the Vix, a crude measure of market anxiety, were similarly dramatic. At one point, its peak was far bigger than on the day of Russia’s invasion of Ukraine².

The sell-off followed a familiar pattern, creating opportunities

Initially, the sell-off followed a similar pattern to other de-risking events. It starts with the dumping of ‘liquid beta’ – think FTSE 100 financials, cyclicals and miners and the buying of defensives, like tobacco, consumer goods, pharma and utilities. Initially, mid-caps and small-caps outperform because of their relative lack of liquidity. Investors sell what is easiest to sell.

In the next stage, investors keep selling liquid beta and start profit-taking in their previous winners, regardless of which sector they are in. In the UK, think Rolls-Royce, 3i and Melrose (the Artemis UK Select fund invests in all three). If the story is that the world has changed for the worse, investors do not want equities and particularly not those at 52-week highs.

The next stage, however, sees investors spotting the opportunities that have opened up and higher-beta stocks find new buyers. We have already seen significant intra-day moves in names such as Barclays.

Absent any further poor or unexpected macro and/or geopolitical news, we would expect markets to stabilise. However, due to the summer holiday and a vacuum of news on the US economy, it may take until September for markets to fully recover their composure. 

Less has changed than market moves imply

Has anything really changed over the past fortnight? It is too early to tell whether recent data on payrolls and manufacturing portend a significantly weaker outlook for the economy.

Personally, I would be cautious about extrapolating too much from two data points that are often revised significantly. Over the first half of this year, however, we had been becoming more cautious on the outlook for the US economy, concerned by unsustainably low consumer savings rates as well as by high levels of personal debt. The US government has its own debt issues too. It will need to tackle its fiscal deficit at some stage, providing a further drag on economic growth.

In the UK, however, the direction of change is actually quite positive...

• The Bank of England has just upgraded its growth forecast for the third quarter to 1.5%³
• PMI data showed British business activity picked up after a lull in the run-up to election, helped by rapid growth in manufacturing⁴
• The recent cut in interest rates may encourage the UK consumer to stop saving and start spending
• In contrast to the US, UK consumers still have a portion of the savings accumulated in the pandemic sitting in their bank accounts: the current savings ratio of 11.1% is significantly above the long-term trend⁵ and materially higher than the 3.4% in the US⁶
• Due to the different mortgage market structure, UK consumers will benefit from lower mortgage rates much sooner than those in the US

Long-term forecast continues to be set fair

So, for those investing in UK companies, particularly those exposed to the UK consumer, far less may have changed in recent weeks than market moves imply. The rest of the summer may be volatile – but we believe the longer-term forecast for the UK economy – and for selected UK equities – continues to be set fair.