197. Why interest rates are likely to go higher in the UK

16 June 2022 (pre-recorded 7 June 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re discussing the UK stock market: from inflation and oil windfall taxes to financials and the hunt for dividends. 

Darius McDermott (DM): I’m Darius McDermott from FundCalibre and this is the Investing on the go podcast. Today I’m joined by Job Curtis, the manager of the City of London Investment Trust. Job, good morning, how are you?

Job Curtis (JS): Good morning, very well, thank you. 

[INTERVIEW]

DM: So your trust is a UK vehicle and as we know, the UK’s been terribly out of favour, particularly since the sort of Brexit referendum. Yet, this year, or year to date, the UK stock market is outperforming considerably, held up whilst other global markets have been falling. Why do you think that is? And do you think that it can continue?

JC: Well, I agree with you. I think UK market has been out of favour and it’s got very cheap relative to other stock markets. I think manifestation you’ve seen a number of takeover bids of UK companies and in City of London, we’ve benefited through our holdings in William Morrison’s last year. And this year Brewin Dolphin and Daily Mail last year as well. But there’s be many other takeovers. So I think that’s helped underpin the market. 

But in addition, the UK stock market’s big in some sectors which have been out of favour, such as oil, which obviously, even before the events in Ukraine, the oil price was climbing upwards. And so that’s been very beneficial to some of our kind of rather “old economy” stocks in the UK stock market. But we still, the world still does need oil. You know, even if in the long run, we’re going to transition to a low carbon type of energy, but in the meantime, oil is still pretty fundamental to societies and the economy. So I think that’s really been a factor behind the UK’s outperformance. 

And on the other hand the UK doesn’t have such big weightings in the very highly rated growth stocks, which have suffered a bit of a derating this year against a background of rising in interest rates and rising bond yields.

DM: Yeah. I mean, I think inflation is hugely important in the market at the moment, but just sticking with that for a moment, large oil, as you say, has been an obvious beneficiary of that rising oil price. Do you have decent exposure to big major oil companies?

JC: Yes, we have a decent exposure. I mean, we are slightly below the UK average weighting. We’ve got holdings in Shell, which is in the top five holdings for the trust. In fact, it’s the third biggest holding at the moment and also BP, but we were quite disappointed in the pandemic. They both cut their dividends quite severely, Shell by two thirds, BP by 50%. They’re now growing them again. But we’ve actually got an also investment in Total, the French international, it’s French headquartered, and that one didn’t have to cut its dividend. And we also more recently have a holding in Woodside, which has been spun out of BHP. It’s an Australian-based international company. And so together we got a decent exposure to oil. You know, it is quite driven by the commodity price itself. So we are participating, but it is a very big part of UK market and we’ve got exposure, but not overweight relative to the market.

DM: Yeah, well still even having a thereabouts market weight will have clearly helped in this high oil price environment, as we all know, every time we go to the petrol station, it seems to be going up every week. 

JC: Yeah. 

DM: Just sticking with those oil majors and the recently announced windfall tax on some companies, how do you think that might impact their ability, because we’ve already just touched on the dividend cuts that the big oil majors in the UK did deliver. Do you think that windfall tax will hurt your dividends going forward?

JC: Oil is a cyclical business and, you know, back in 2020, the oil companies were really struggling when the oil price was much lower than it is now. So they have to make money during the up swings in order to invest the huge amount of money they need to invest in order… because their assets deplete the whole time as the oil wells produce go into production. You know, I think in terms of BP and Shell, these are global businesses, it’s a tax that only really applies to the North Sea and their profits from coming from there, which are a small part of the whole and can be offset by the investment they’re making in the North Sea. So I don’t think, you know, in terms of those two companies, it’s that meaningful. 

But having said that, it’s not a very good signal for the UK in terms of attracting global investment in the North Sea. I mean, oil companies will weigh up prospects in the North Sea against various other places round the globe – where they can drill where there’s oil. And you know, if they’ve got sort of tax regime, which is not very clear in the UK, that’s going to be quite a negative factor in terms of where they put their new investment in going forward I would say.

DM: Yeah, I think you’re absolutely right about the North Sea, but just government interference on listed companies owned by shareholders is in itself questionable, in my humble opinion. 

JC: Absolutely. 

DM: So let’s have a look at the trust. I see you’ve got gearing at around 8% at the moment. Is that sort of structural gearing? Is that at upper or lower end of your typical range? And is that hence a reflection on your view on the UK market going forward?

JC: We’ve borrowed through some private placement notes in recent years, and these have now got very attractive coupons for what you could borrow nowadays given the rise in interest rates. So I mean, we’ve borrowed for out till 2047 at 2.67% and out to 2049 at 2.94%. So these are very attractive interest rates to borrow at and the 8% gearing really reflects those private placement notes.

DM: Right. 

JC: And it’s a strategic view that we in the long run, we can beat that, those coupons on an annual basis. And if we can’t, I think it’s going to be quite a sort of desperately sad environment for investors. So that’s really structural. I mean, we have capacity to have further gearing, but we are a conservative fund. At the moment, you know, there are a lot of uncertainties out there with inflation where it is, interest rates rising, bond yields rising, you know, we’re being very careful of how we invest money, but, you know, we do think we have got that strategic long-term borrowings. We’re keen to keep those deployed in the market.

DM: Well, you’ve touched on the I-word inflation. So let’s not dance around the handbags anymore. Let’s get to it. I mean, how worried are you about inflation and, you know, slowing growth in the UK? And how does that sort of impact your thinking for the trust?

JC: Well, I think during the pandemic, the government and the Bank of England both stepped in as did other governments, central banks and, you know, sort of saved the country going into a depression potentially. And there was a massive fiscal stimulus and also monetary stimulus and interest rates cut to almost zero and the Bank of England, you know, bought up lots of bonds. And I think in, you know, the benefit of hindsight that probably carried on for too long, particularly the central bank activity and a lot of money got injected into the system. And now everything’s reopened again. There’s really an excess of demand for the amount of supply and that is leading to inflation. 

And it’s not just, we’ve talked about the oil price and which has had an knock on effect on the electricity price and the utility bills, but also it’s the labour market, you know, where obviously it’s very good that unemployment’s so low, but there is a real shortage now in, I’m sure we’ve all anecdotally, you know, been in restaurants, bars, where they’re short of workers and so wage inflation is creeping into systems. So we’ve had a serious… interest rates up taking it or the Bank of England’s base rate, to 1%, but with inflation at the moment, 9%, that still looks very low compared to, you know, what we can remember when we were younger you know, back in the eighties, et cetera. 

So my view is interest rates will go have to go further up to slow things down. Because in the end we all get robbed by inflation. So they do need to get it under control. I mean the UK stock market actually has got quite a few – it’s one of the reasons why it’s holding up well, and we talked about oil earlier – but it has got various sectors that are quite well protected against inflation and City [of London] is well positioned in those parts of the market. So it’s not totally negative for equity investors. I think there are companies that will have got kind of inflation protection in terms of their business models and type of sectors they’re in.

DM: And you said a moment ago that this is a cautious fund, a cautious company, are you sort of gently worried? We talked about that tipping point, I suppose, between central banks raising rates to stop inflation, but also will that take us into recession? Do you have any defensive sectors that you’re playing? Or are you just doing what you’ve always done, which is, you know, look for attractively valued companies with some margin for error?

JC: No, I think you know, I’m deliberately got reasonable weightings in some of those areas for protection. I mean, some of the utility sectors are well positioned from that point of view where we’ve got good weightings, mining is another sector which has done well. And again, you’ve got some protection, real estate investment trust, you know, depending where they’re positioned in the real estate market, companies with strong pricing power like British American Tobacco, Imperial Goods also, we got big weightings in. 

And on the other hand, we’re quite underweight in consumer discretionary. These are the sectors that are most exposed to consumer like retailing and to some extent travel and leisure where, you know, I think the dividends will be slow to kind of recover as well. And so we’ve actually we’re underweight in that part of the market. So, I mean, basically, City [of London] is managed on a kind of bottom up basis looking at the companies and trying to evaluate the you know, where the growth prospects are reasonably rated and you can pick up good dividends as well. But on the other hand, I do have a macro sort of overlay and to some extent, and that is forming part of my thinking at the moment.

DM: Yeah. So let’s see if we can get our crystal ball out now and have a go at looking forward. Are there any themes or trends that you see within the UK market that either you are already accessing or that you may access going forward?

JC: One area that I like in the UK stock market is financial groups. I think this is something the UK does well. And I’m talking here in particular insurance, non-life insurance, and sort of financial services, and we’ve got some heavy positions in this part of the market. And you know, earlier this year, Brewin Dolphin, a private wealth manager was bid for and that at a price, you know, well above where previously been trading over 60% premium. 

DM: Yeah. 

JC: And so I think this part of the, you know, I think there’s a lot of demand out there for good advice on savings. And you know, I think there’s some natural structural growth drivers in this part of the market. So I do favour and I think also a rising interest rate environment tends to be quite good for insurers. 

We’ve also got exposure – we’re slightly underweight the bank sector – but we have got exposure to banks and they’re in a much better position than they were going back pre-financial crisis. Their capital ratios are much stronger, and they are reasonably valued. You know, they obviously have an inherent volatility, and if this economy tips into recession, they would suffer. But overall we do have exposure to three banks, but slightly overweight that sector, but I like financials in general. I think it’s an area the UK does well and looks very reasonably rated in to me.

DM: Yeah. I suppose maybe an ageing population and a rising interest rate sort of theme. 

JC: Absolutely 

DM: Which you say the UK is well represented in some of those areas. So, Job, maybe just lastly, you know, I know you’ve been running the City of London for 30 years now. What has the past three decades taught you about investing and what little snippets can we rob from you for our listeners, that you’d like to pass on?

JC: Well, City [of London] sets out to be conservative fund. I mean, obviously growing our dividend on an annual basis is very important. And I think just sticking to those objectives, you know, it is crucial and, you know, I can remember the technology bubble at the end of the 20th century. And, you know, it felt very uncomfortable for a while not to be in some of those kind of loss-making, zero dividend yielding type shares when they were soaring outputs. But I was very pleased not to be in them when they started crashing back into earth again. 

And I think you just, you know, I stay kind of very fixed on the fund’s objectives and you know, I think what we offer shareholders and try not to get too distracted by the noise in the market. And so I think that’s some, I mean, obviously you can’t be arrogant and you’ve got to constantly adapt, you know, to new trends, but overall I think the sort of key principles, you know, I try and keep laser-focused on.

DM: I think maybe I’ll just add to that for you, you know, the dividend discipline that City [of London] has and that you’ve always brought to City of London Investment Trust, over very long periods of time, dividends do make up a decent part of total return of equities. And, as you say, this is exactly City’s objective. So Job, thank you very much for taking time to talk to us today.

SW: Launched in 1891, the City of London Investment Trust is one of the longest-running investment trusts in the UK and has increased its dividend payment every year for the past 55 years. To learn more about the City of London Investment Trust fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.