The outlook for UK markets

Guy Anderson discusses his investment approach in addressing the unprecedented reduction in oil prices.

Guy Anderson, Manager, The Mercantile Investment Trust plc

View the Mercantile company profile page

The unprecedented reduction in oil prices is likely to be one of the most significant macro factors impacting UK stocks this year. As a result of this catalyst, we have refined a number of the largest holdings in The Mercantile Investment Trust, recycling capital out of some of our longstanding investments into a combination of new ideas and existing holdings in order to reposition the portfolio so as to capture this profound change. 

Although oil prices have started to stabilise, with Brent crude rising above $60 a barrel, this does not detract from the significance of the sharp declines we saw from the peak of $115 per barrel in June of 2014, the effects of which are only just beginning to be felt by UK companies and consumers. 

The UK is a net importer of energy and whilst there are a multitude of second order effects, this reduction in import costs is positive for the UK consumer and for UK GDP. The price of commodities declining has a temporary downward effect on inflation, which in turn has two clear derivatives. First, it increases the likelihood of consumers experiencing real wage growth for the first time in the last five years. Second, it pushes out, for a period of time, the point at which interest rate tightening will commence. The combination of these factors has made us incrementally more positive on the outlook for household cash flows and consumer discretionary expenditure, and consequently for those companies, such as retailers, that will benefit from this directly.

Conversely, this dramatic fall in the price of crude oil is negative for those companies that are positively correlated to the commodity price. As a result, and given our view that this is not yet fully reflected in valuations and earnings expectations, we are currently negatively positioned in energy and related industries.

Following the financial crisis we built a significant overweight position in the Housebuilding sector. As the UK housing story played out and valuations began to reflect more stable market conditions we sought to wind down this exposure. 

Among consumer cyclicals we are invested in companies such as Dixons Carphone and B&M European Value Retail. Each of these retailers has sustainable competitive advantages and operates in attractive end markets – key characteristics sought in our stock selection process. Another way we are playing the trend is with SSP, the operator of food retail outlets in airports and railway stations, which is poised for continued strong cash generation as the UK consumer recovers from recent headwinds and regains spending power.

We aim to seek out investments that will do well irrespective of the political weather, like the ‘innovators’ within our small and mid cap universe that are experiencing periods of positive change. We own a variety of companies that are shaping their own future with innovation. For example, internet platform businesses such as Moneysupermarket.com and Rightmove occupy strong market positions and offer a combination of significant growth and high profitability. The recent IPO of Auto Trader is another example of a successful internet platform, constantly innovating to ensure their competitive positioning is sustained.

The upcoming General Election may be hugely significant for the UK and the UK market, given the wide range of outcomes and potential implications for specific companies and industries. However, the election is just one of many factors influencing the stock market, and over the long term we believe that the underlying strength of the UK economy, the diversity of UK corporate earnings and a number of company specific drivers will support continued earnings progression. However, given broader macroeconomic uncertainties and currently elevated valuations we expect that overall market levels are unlikely to make more meaningful progress until we see evidence of this earnings progression.

As a result, the portfolio is fully invested but un-geared at present. This leaves us with the option to deploy further capital into the market if volatility creates worthwhile buying opportunities or as these risks unwind.