Chief Investment Officer’s Corner

Here are three themes at the forefront of Rathbones Investment Management's Co-Chief Investment Officer Edward Smith’s mind, and what they mean for our clients’ investments.

By Edward Smith 12 February 2024 Edward Smith

1. The importance of staying invested

If you were to take one lesson only from 2023, it has to be the importance of staying invested. We had lots of questions from clients and advisors in the middle of the year asking why they shouldn’t divest everything and stick it in cash earning five or six percent. 

Well, we back-tested the effect of ‘cashing out’ at the various peaks in cash rates since 1960 – as you can see from the first chart, it has tended to mean losing out on a lot of return. There were a lot of anxious moments over the past year, but in the end equities comfortably beat cash in 2023. NB: past performance is not a reliable indicator of future results.

Performance of US equities vs cash portfolios: median performance (%)
following the peak of interest-rate cycles since 1960
Equities versus cash since 1899
Performance of US equities vs cash portfolios:  median performance (%) following the peak of  interest-rate cycles since 1960
Equities versus cash since 1899

Source: LSEG, Bank of England, Rathbones

 

At Rathbones we anchor our investment strategies around what we believe to be the optimum long-term allocation to different asset classes. We then find companies and other investments that we can believe in over the long term, preferably aligned to the major themes of a changing world. We do make tactical tilts towards or away from certain risk factors in response to the major turning points of the economic cycle, because that’s when the dispersion of returns tends to be at its widest, both within and across asset classes. This presents the greatest set of opportunities for active investors. But the discipline of anchoring our investments around this strategic asset allocation is paramount. 

 

2. Fantastic reduction in inflation, but some lingering US uncertainties

Inflation is the enemy of the investor, and the lowest yielding assets such as cash are particularly vulnerable. But there has been a profound degree of disinflation over the last six months. 

You can calculate inflation in various ways, but the main ‘headline’ measure is the Consumer Prices Index (CPI). Averaging the inflation of 38 advanced economies, we find that it took 14 months for this standardised measure of CPI to peak after it broke above the historic average in 2021. It's taken 13 months for it to fall within spitting distance of that same threshold. In other words, it’s fallen almost as quickly as it rose. 

The path of inflation (%)

 

2.	Fantastic reduction in inflation, but some lingering US uncertainties

 

Source: LSEG, Rathbones, based on a standardised measure of consumer price inflation (CPI)

Now is that mission accomplished? Core inflation – which excludes volatile food and energy prices and is more representative of underlying inflationary trends – is on track to do the same, but it still has a lot further to go. 

The final few miles may be bumpy, but our research shows good evidence that there is more disinflationary pressure in the pipeline, not least because central and commercial banks are no longer creating excess money.

Headline inflation data is based on the 12-month rate of change. Six-month core inflation rates are well below the annual rates in the US, UK and the Eurozone. In other words, there’s been great disinflationary momentum of late.

But there is some significant regional variation. The three-month rate of change is even lower in the UK and the Eurozone. In fact, Eurozone prices over the previous three months are deflating – i.e. falling prices not just falling inflation. 

It’s not our base case, but there is a risk of US inflation getting a little stuck on the home straight. The three-month rate of change has been rising since the autumn. We think US inflation will end 2024 lower than it is today, but we must acknowledge that some gauges are heading in the wrong direction. Investors should be compensated for this lingering uncertainty in bond and equity market pricing, and a realisation of that could cause some volatility in the first half of the year. 

 

3. Are UK equities cheap, or cheap for good reason?

Long gone are the days when UK equities made up the majority of the average UK wealth management portfolio. We see that as a good thing in general, given our firm belief that a global mindset is important for delivering superior risk-adjusted returns. Still, the cavernous gap between the valuation of UK companies and their peers overseas is worth investigating.

On some measures, this gap is wider than it has been since the 1970s. We often hear the rejoinder that the UK market deserves to trade at a significant discount, because it is weighted towards old-economy sectors and has fewer fast-growing and high-quality firms than the US. There’s certainly an element of truth to that view. The UK clearly has no direct equivalent to the US tech giants. But what it doesn’t tell us is how much of the valuation gap is due to the composition of the UK market, and how much (if any) is a genuine discount. Or in other words, cheap for a reason or good value.

We’ve deployed some statistical tools that allow us to control for all kinds of relevant characteristics which can affect valuations, helping us account for differences in composition between markets. We can use it to compare valuations on an apples-to-apples basis. 

On this basis – without making any adjustments –the price/earnings (PE) ratio of the average UK stock is 32% lower than that of the average US stock. If we control for sectoral composition, the gap narrows only marginally – to 28% versus the US – meaning UK stocks trade at a discount to their US counterparts within the same sector. When we also control for various other factors, including sales growth, profitability and balance sheet strength, the gap once more remains large, at about 22%.

Essentially, this means that firms in the same sector with identical growth and quality characteristics trade at a lower multiple if they’re listed in the UK rather than the US. That’s very hard to justify.

Average gap between UK & overseas P/E ratios in our universe

Average gap between UK & overseas P/E ratios in our universe

Source: LSEG, I/B/E/S, Rathbones *other characteristics include sales growth, profitability and balance sheet strength

This analysis also confirms that the UK discount emerged after the 2016 Brexit referendum. The vote to leave the EU arguably increased the uncertainty around the UK’s long-term economic outlook. However, even if you’re very pessimistic about the economic consequences of Brexit, the discount described above still doesn’t look logical. We found that multinationals whose earnings are largely overseas face the same discount as UK companies with a purely domestic focus.

Valuations tell us nothing about an investment’s prospects over the next 12 months. But there is good evidence that they can tell us a lot about the variation in returns over the long run. We are global investors looking for great companies in many jurisdictions, but UK equities shouldn’t be cast aside.