A new mood in markets: positioning for recovery

The narrow focus of markets in 2020 may have left investors positioned for yesterday’s crisis rather than tomorrow’s recovery, says Thomas Moore, manager of the Aberdeen Standard Equity Income Trust.

• A rotation in stock markets is being driven by the prospect of economic recovery as vaccinations allow economies to reopen
• Stock markets are likely to move ahead of the economic data
• There is a window of opportunity to benefit from low valuations as the wall of worry is set to be climbed

 
In potentially delivering a route out of the pandemic, vaccines have also brought a notably different mood to markets. For much of 2020, investors were narrow in their focus, concentrating on a handful of consumer staples and technology companies that could deliver strong earnings even as economies shut down. However, in recent months investors have started to broaden their horizons.

Given our focus on identifying under-appreciated UK income stocks with the potential for stock-specific change, the highly-charged macro environment that prevailed in 2020 was a difficult one for the Aberdeen Standard Equity Income Trust. Style analysis shows that there was general antipathy towards income stocks globally, with UK income stocks performing particularly badly on fears of a no-deal Brexit.

However, as vaccines pave the way for economic recovery and an eleventh-hour EU-UK trade deal reduces political uncertainty, investors have started to appreciate the robust prospects and inherent value in many unloved and unfashionable UK stocks. We believe investors should take note.

We are still in the foothills of this rotation and many investors may be unprepared for what is to come. The strong performance of a handful of growth stocks has left global equity markets unbalanced, with many investors reluctant to shift away from the companies that have served them well through the crisis. However, it may be time to switch gears and think about recovery rather than crisis.
 

Positioning for economic growth

 
While there are risks to the vaccine rollout and the potential for resistant mutations of the virus, there are also reasons for optimism. For example, we see household finances as a powerful catalyst.

For 12 months, many people have curbed their spending: holidays have been cancelled, commuting costs have disappeared and few have felt the need to update their wardrobe.

A recent Bank of England survey showed around 28% of households had accumulated additional savings, mostly among wealthier and older people.

Household savings ratios are at multi-year highs, hitting 16.9% in September 2020. We expect some of these savings to find their way into the economy once people have a little more certainty about the future.

At the same time, governments are likely to continue spending, particularly in the UK. As the architect of Brexit, the incumbent government will be keen to prove its success, which could see lower taxes and deregulation.

The EU-UK free trade deal is not perfect, but it is a baseline. Subsequent free trade deals are likely to boost sentiment, highlighting that the UK remains open to the world. Gradually, this may start to unwind the Brexit discount that has been placed on the UK market.

The UK has undoubtedly been held back by the sector composition of its stock market as global growth was slowing. It has a higher weight in more economically-sensitive areas such as energy and financials.

Just as this held the UK market back during a time of uncertainty, it should be supportive as the economy recovers and capital rotates into these unloved areas.
 

Cheaper growth

 
It is worth noting that many of the companies in our portfolio have been out of favour not because of underlying weakness in their business, but simply because they were unfashionable. The market has ignored many businesses whose operations have held up superbly well during the crisis.

The divergence in valuation multiples within the UK market has increased as investors follow simple rules of thumb that have worked very well during a prolonged period of falling bond yields, but which may come into question should the external environment ever change.

The result is that investors could be over-valuing the earnings stream of certain businesses and significantly undervaluing the earnings stream of others.

The scale of the valuation opportunity is such that investors can position for recovery without taking on a huge amount of risk. We see many robust companies offering a combination of attractive yield and growth.

Our experience tells us that the start of a new cycle offers the greatest opportunities, as this is when investors are at their most uncertain despite the burgeoning growth that lies ahead.

We are particularly excited about financial services companies which have weathered the downturn successfully and now look set to reap the benefits of the up-phase of the cycle.

For example, emerging markets fund management group Ashmore turned out to be far more robust than the market anticipated, with a strong balance sheet supporting an attractive dividend and investment in growth.
 

Dividends

 
Covid-19 had a major impact on UK dividends and this has resulted in our portfolio income slipping back, requiring us to dip into reserves to support the payout to shareholders this year.

We still have considerable reserves, but as a newly anointed AIC ‘dividend hero’, we are working hard to restore our portfolio income as soon as we can.

Given the number of attractive income stocks available, we believe we can do so while remaining consistent in the investment process that we have set out.

As well as adding to our holdings in attractively valued resilient income stocks, we are expecting around one fifth of our portfolio to reinstate dividends in 2021.

The long period of sluggish economic growth and low bond yields has conditioned investors to believe that there is only one formula that works. This has resulted in many well managed companies being left behind.

While there are early signs of a shift in tone, we believe there is a very long way to go. Investors need to consider whether they are positioned for the economic recovery that lies ahead or the crisis that has just happened.

Company selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.
 
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