IFAM: How do you see the current economic and market uncertainty in the UK impacting the performance of smaller companies in 2020?
JONATHAN BROWN: Extended political and economic uncertainty has weighed particularly heavily on the smaller company sector due to its greater exposure to the domestic UK economy. The sector has been shunned by many investors due to the lack of visibility over the UK’s future trading relationships. This has led to the sector trading at a discount to historic multiples. However, we are hopeful that a reasonable Brexit deal can be approved over the coming months and that would bring much needed clarity, potentially encouraging investors to increase exposure to the domestic UK economy and by extension, UK smaller companies.
IFAM: Where do you see the biggest opportunities for growth in the smaller- cap sector and why?
ROBIN WEST: We are currently taking a “bar bell” approach to constructing our portfolios due to our conflicting views on the short and long-term prospects for the economy.
In the short term we believe that a reasonable resolution to Brexit could unlock pent-up activity in the UK economy. We have met numerous businesses that are taking a “wait and see” approach ahead of any agreement being finalised and we think this is mirrored in the consumer sector, where bigger ticket purchases have been deferred. Once we have better visibility on future trading arrangements some commentators believe we could see a circa 1.5% benefit to GDP growth. For this reason, we have increased our weighting in better quality domestic cyclical stocks.
JONATHAN BROWN: In the longer-term however, and on a global basis, we believe the period of sub-par growth that has persisted since the financial crisis will continue. The secular drivers of the global economy are demographics, productivity and debt. GDP is a product of how many people are in work and how productive they are. For the first time in history we are seeing the working age populations shrinking in most major economies. When combined with low levels of productivity growth, it is easy to see why GDP growth over the last decade has struggled to keep pace with historic norms. Overlaying this is debt, which has reached unprecedented levels both governmental and individual. The process of “leveraging up” since the early 1980s has accelerated economic growth, but it seems likely that this could diminish in future. So, in light of this, we also favour stocks with “self-help” characteristics that enable them to grow independently of the economy. This can include the restructuring of underperforming businesses, sector consolidation, roll-out strategies or market share gains led by innovation.
IFAM: On the flip side, where do you believe that the biggest risks to performance lie?
ROBIN WEST: We would say that the biggest potential risk to the global economy emanates from the mistaken belief that economic prosperity can be enhanced by rejecting free trade. This obviously has strong parallels with the policies enacted during the Great Depression of the 1930s (e.g. the Smoot–Hawley Tariff Act). The policies seem to garner support from electorates as they are seen as simple solutions to complex problems, but history shows that whilst the impact can be initially positive, ultimately it is destructive to economic activity and prosperity. Whilst we remain hopeful of a reasonable outcome to the Brexit negotiations, and that the US will de-escalate its trade war with the rest of the world, the potential for economic and market disruption looms large.
JONATHAN BROWN: I would just add to that, that the main driver of markets, and asset prices in general, is liquidity rather than the economy. So, whilst the outlook for profit growth has become more difficult, the resumption of monetary easing via lower interest rates and the potential for more creative forms of economic stimulus should continue to be supportive for equities. Bond yields are plumbing new depths, with investors showing appetite for negative yielding debt with durations as long as 30 years in some cases. Within this context we believe that equities look very attractive.