When domestic economic or political trends diverge from the rest of the world, both opportunities and risks are presented, says Alan Dobbie, Rathbone Income fund manager.
Post-pandemic inflation is proving much harder to supress in the UK than in the US or Europe.
CPI fell almost 1.5 percentage points to 8.7% in April as huge 2022 energy price moves started to fall out of the annual numbers. But the Bank of England (BoE) had expected a drop to 8.4% in April. That wasn’t to be, however, as food inflation didn’t budge, and transport and recreation prices accelerated.
While US investors deliberate over when the Federal Reserve will begin cutting rates, UK investors are left questioning how many more Bank of England rate hikes are needed to quell a burgeoning wage-price spiral. Gilt yields rose sharply with the 10-year jumping above 4.3%, although they have since fallen back, underscoring the rate uncertainty.
When our domestic economic or political trend diverges from the rest of the world, it always presents opportunities and risks. This is because the benchmark FTSE All-Share Index makes roughly three-quarters of its sales overseas, meaning the index’s performance tends to be more closely tied to global GDP, US monetary policy and geopolitics than domestic affairs. As an example, in 2022 the FTSE All-Share managed to eke out a 0.2% total return. This was driven by the 10 largest (multinational) constituents rising an average of 30% and the remaining 575 stocks falling by an average of 15%.
While headline index performance may be only somewhat linked to domestic affairs, for a great many stocks, domestic inflation and the path of UK interest rates are crucial to their fortunes. This is especially true for housebuilders and domestic banks.
Though both sectors are closely linked to the fluctuations of the UK economy, their performance often differs markedly. While it’s true that overleverage, overconfidence and overvaluation crushed both sectors during the Global Financial Crisis (GFC), their performances in the years since have diverged. In the 11-year stetch from the market bottoming in March 2009 to the early days of the pandemic in March 2020, UK housebuilders returned 280%. This was well ahead of the FTSE All-Share’s 133% and in a different league to the UK banking sector, which returned just 33%…remember this was the period after the banking crisis! However, since March 2020, their relative fortunes have reversed. The banking sector has returned 57%, the FTSE All-Share 45% and the housebuilders have fallen 12%…quite a divergence for two economically sensitive and domestically focused sectors.
So where do we stand on these important income-generating sectors today?
Housebuilders – troughing?
Despite typically being regarded as a ‘value’ sector, UK housebuilders didn’t join in the 2022 ‘value rally’. In fact, the sector fell 40% over the year. This was at odds with relatively robust housing market fundamentals. UK house prices rose 10% in 2022, transactions were decent enough and housebuilder profitability was strong. However, stock markets are forward-looking and they saw what was around the corner: the end of Help to Buy, sticky build cost inflation and falling mortgage availability and affordability – particularly after the mini-budget pushed interest rates much higher. By the end of the year, the housing market was in stasis.
This year things have improved. Still bad…but better. And it’s this change in momentum that has driven most housebuilder stock prices higher. As mentioned above, the job of the stock market is to anticipate real world changes. Mortgage availability has increased, mortgage rates have fallen, build cost inflation is dropping and buyer confidence is returning. Further, the main political parties know that helping first-time buyers onto the housing ladder is always a vote-winner. Expect new housing policies running into an election year.
It’s too early to say whether higher inflation will snuff out a nascent housing recovery. But, on balance, we think valuations, balance sheets and dividends are positive.
Banks – peaking?
In contrast to housebuilders’ gloomy post-pandemic performance, domestic UK banks have cheered. After more than a decade of declining interest rates, higher inflation spurred a turn in the rate cycle, delivering banks their first profit tailwind in years. We have some concerns, however, that increased competition and the need to pass on more of the rate-hike benefits to depositors may crimp further profit growth. The prospect of peak rates and global recession are further risks for a highly economically sensitive sector.
More positively, capital positions remain strong and valuations attractive. Banking sector dividends have returned with aplomb after being suspended in 2020. UK banks offer attractive dividend yields with the prospect of dividend growth and potential for buybacks – a far cry from a miserable post-financial crisis decade.
Still, we think the best of the bounce is behind the banks now, so we’ve moderated our exposure. We haven’t yet piled into housebuilders, albeit we own small positions in several. We think they will look very attractive once their fortunes trough, which could well happen this year.
