Ahead of the Bank of England’s March interest rate decision, I spoke to Simon Brazier, co-head of Threadneedle’s UK equities team and manager of the Threadneedle UK Fund. The following are excerpts from this interview, in which Brazier discusses his outlook for interest rates, explains why he’s less optimistic about UK economic growth than the government is, and outlines where he sees attractive UK equity opportunities and why.
On the Outlook of Interest Rate Hikes
The market has now effectively priced in two to three interest rate rises before the end of the year. My view is simple: Mervyn King will attempt to keep interest rates low for as long as possible because he understands there is a balance between fiscal tightening and loose monetary policy. Having said that, if CPI inflation remains at its current level, it will not be surprising to see one or two interest rate hikes before the end of the year. But let’s put this in context: interest rates between 1.0% and 1.5% are still incredibly low on any basis and relate to a relatively loose monetary policy. The only people really affected by such changes will be those on tracker mortgages.
On How Markets Could React to an Interest Rate Increase
A key consideration is, when interest rates go up, why they are going up. If it is due to short term inflationary pressures related to commodity and oil price increases or food inflation, then the market will be less worried. The situation will be different if we are seeing persistently high oil prices, which is a genuine tax on the economy, or wage inflation. The latter is something that the Bank of England is monitoring closely. Wage inflation is a ‘sticky’ inflation – someone’s salary cannot be increased by 5% one month and decreased by 5% the following month.
If we were to see an interest rate hike as a response to ‘sticky’ inflation, the market will take that quite poorly. But we are not quite there yet. Ultimately, I believe that Mervyn King holds the view that inflation is driven by short-term factors at the moment and those will eventually fade away; therefore interest rate levels do not need to be as high as some suggest.
On the Economic Environment in the UK
We have come out of the deep downturn but one should not forget there are still significant risks to the UK economy. In fact the risks we see in the UK are also facing the rest of the developed world; they relate to government finances and borrowing, cost-push inflation, and sovereign debt contagion.
It is unlikely that we will see a second quarter of negative economic growth, simply because there were some significant one-off factors that weighed on the economy in the last quarter of 2010, such as the snow. Having said that, we expect to see 1.5% GDP growth in 2011, while the government’s projection is 2.6%.
The reason our forecast is lower is because we believe the fiscal consolidation measures which will come this year will constrain growth. The government Budget planned for fiscal consolidation of £8.9 billion in 2010/2011, whereas the 2011/2012 budget envisions £41 billion in cuts. State spending, which had been a strong contributor to growth in the 1990s and the 2000s, is definitely not there anymore. Additionally, we cannot see the consumer forging head in an environment of potentially rising interest rates and an uncertain job market. The trade balance is also not improving despite weaker sterling.
On Drivers of UK Economic Growth
The only area of the economy where both we and the government are seeing growth is the corporate sector, but that is not enough to lead a 3% GDP rebound.
We are following what happened in Canada and Sweden in the early 1990s. These are two countries which undertook significant fiscal consolidation--a policy which we believe is a necessity rather than a choice for the UK government at the moment--and came out of their downturns in a much stronger position. This can be attributed to the fact that as they undertook fiscal consolidation they also pushed through a number of private sector reforms, getting rid of red tape and putting the private sector back at the heart of recovery.
And that is what Cameron and Osborne are trying to do at the moment. Policies such as reducing National Insurance contributions send a clear message that the government wants the private sector to lead the recovery. The clearest message is that the government forecasts that in 2011 the biggest growth will be seen in business investment: 8% annual growth, compared to a 1.6% increase in household consumption and a 19% decrease in public investment.
On UK Companies in the Current Economic Climate
Companies based in the UK, be they UK-focused or overseas-focused, are in a very strong position in terms of their balance sheets. Actually, the real issue for most UK companies was not 2009/2010, it was 2001/2002. A lot of companies were burnt from investing in internet-related unprofitable ventures at that time and from 2001 through to 2010 companies have significantly increased the amount of cash on their balance sheets and are in a much better position.
Many UK companies have used the recent downturn not to rebuild their balance sheets but to undertake strong structural reforms, which is why we are seeing many companies already coming through with much higher profit margins.
On Picking Quality UK-listed Companies
Valuation is key for our portfolio strategy. We were buying industrial stocks at the end of 2008 because they were looking very cheap relative to their growth prospects. In the last six months, we have been finding a lot more value in companies such as JD Wetherspoon (JDW) or some of the bus and rail companies, which may not have the economic tailwinds, but are generating a lot of cash and we believe they have downside protection. If the economic growth comes through, these companies will look very cheap, but they look attractively priced at the moment as well.
Our approach to companies whose main operations are outside the UK is similar. Since 70% of sales of UK-listed companies are based overseas, global economic growth is something we like seeing, but we make our portfolio allocations based on what the structural demand for a company’s product is in its region of operations.
For example, Wolseley (WOS) is a typical UK-listed company with significant operations in the US. It has delivered very strong share price performance, driven mainly by the ability of that company to restructure and refocus on areas that are profitable. It will be brilliant for Wolseley if US economic recovery comes through, but at the moment there is a significant amount of self-help.
Limiting downside risk is also something we discuss a lot when considering investing in a company. Downside protection usually derives from three factors – having a strong balance sheet, a good management team, and operations in a strong structural growth market which is not as cyclical as the economy.
An example of a company which has considerable downside protection is Persimmon (PSN), since the value of company is less than the real estate on its balance sheet. This is also a company which has not relied on macroeconomic recovery to deliver strong profits, and that’s because it restructured during the downturn.
