320. Navigating 2024 and the UK small-cap surge

29 June 2024 (pre-recorded 26 June 2024)

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): Hello and welcome to the Investing on the go podcast brought to you by FundCalibre. I’m Staci West, and today I’m joined by Darius McDermott and Juliet Schooling Latter for our market update. Given it’s the end of June, we’re going to be taking a look back at the first half of the year more broadly, and of course, looking ahead to what could be in store for investors for the second half of the year. So, Darius, Juliet, thanks for joining me.

Darius McDermott (DM): Morning.

Juliet Schooling Latter (JSL): Morning, hello.

[INTERVIEW]

SW: Now, I’m sure listeners will want to hear your views on the UK elections, which are next week. But before we get to the political elephant in the room, let’s just recap where we are with markets briefly.

So, we’ve seen good performance from technology and US funds so far this year, which is probably not a big surprise. But the thing that I particularly wanted to talk about was UK smaller companies, which were the fourth best-performing sector so far this year, which even outperformed global equities. And given it’s a personal favourite for both of you on this podcast, I thought that’s where we would start today.

So are the fortunes turning for smaller companies? What’s happening? What has seen this great boost of performance so far this year?

JSL: Yes.

Sorry, were you hoping for a slightly longer answer? <Laugh>

I mean I think the value in smaller companies is sort of finally starting to be recognised. You know, there’s been an increase in M&A and share buybacks continuing. As you know, at at least the companies themselves recognise that value, there value. But there’s no doubt in my mind that this got further to go because they haven’t actually made up for all that they’ve lost over the past few years, particularly UK small-caps.

DM: Yeah, I mean, it’s only just begun. It’s the simple way of putting it. We’re talking about fairly modest returns in the first half of this year. Yes, it’s one of the better sectors. But, you know, we spent the entire year and probably the last 12 months talking about the value in smaller companies, particularly UK smaller companies. So the fact that they have at a better start to the year, great, but it’s not like they’re up 90% and the ship has sailed. We’re up roughly 10% when we looked at the numbers earlier in the week and it is one of the better performing sectors.

So yeah, hopefully the corner has turned and people starting to recognise value as Juliet said, you know, so some good companies in small-cap M&A is definitely picking up as either companies or their rivals are recognising that other companies are cheap and companies are also doing share buybacks, even in small-cap, which is when companies management recognises their shares are cheap and you actually can increase your earnings per share, which should in turn boost your share price over time.

So yeah, the start of it. The one thing we do know, small companies always volatile, so they won’t necessarily all go in one one direction if something happens in global markets that causes the markets to broadly go down. Smaller companies always tend to go down more. But if that was the case, then it would be time to to to pile in.

SW: And on the flip side of things, we see fixed income very heavily at the bottom of the table. So seven of the 10 worst-performing sectors so far have been fixed income. What’s happening in fixed income? What needs to happen going forward for the second half of the year to see a recovery in bond markets?

DM: Well, I could give you every bit of brief an answer as Juliet did to question one, but in the spirit of giving some commentary: this is all about rates, it’s as simple as that.

At the start of the year, the consensus was in the states for seven rate cuts. We never believed that, but that’s what the market was telling you. And in fact, the Feds dot plots we were gonna get seven cuts this year. Here we are, as you say, halfway through the year, we’ve had none. And that’s the answer to your question, why fixed income is done so averagely, it’s because the rate expectation has been going all over the place and not down.

And the second half answer to the question is, of course, what happened needs to happen is rates are actually finally gonna go down. And if they do, that should be, but will be positive for fixed income. But Jules, I don’t know, do you have a strong view of whether rates will actually go down or not?

JSL: Well, I’m sort of agreeing with what Darius says really. And I mean, I think the jury’s out a bit. I think we will, I think there’s no doubt that we will — we will see rates going down. It’s just sort of when and how quickly, and that’s what bond markets are waiting to see. I imagine that we will get rate cuts here and in the US this year, but you know, probably only one.

DM: One to two would be my best guess. Yeah, maybe two in the UK potentially naught to one in the States because the economy’s still so strong and inflation hasn’t gone away. And you get the odd month where inflation is more sticky than expected. And the odd month where it’s slightly less sticky than expected, but either way it’s still above target, which is 2% in the States and the UK, even if it is trending back towards that and hovering some of the inflation figures are hovering around the two. But then you look at sort of the goods and the services inflation and they’re stubbornly high. So we may see one potentially two later in the year, but I wouldn’t say that with high conviction,

SW: Once again, we see Latin America as the worst performing sector over the last two quarters. It’s down 15% year to date. So just briefly on this one, does Latin America have the potential for growth despite the losses and they’ve got high inflation, it is a difficult place to be looking as an investor. There’s limited number of funds in that region as well. Is it about being selective or is there something else going on?

JSL: Well, I mean, Latin America, it’s always been a bit of a wild card, hasn’t it really? And it’s characterised by political instability at the moment – where isn’t today – and high inflation as you say. And it’s often at the mercy as well of global growth and commodity prices. It’s also sort of been hit a bit by US rates not coming down as expected as we’ve just talked about. So it’s hard to say really. I mean, Brazil is obviously one of the large markets there and government spending there is continuing to rise which looks a bit like sort of fiscal mismanagement. So it’s a tough market, I think. And I think if you do want to invest there, you just put a little small amount away whilst it looks cheap and then sort of stick it in the back of the cupboard for 10 years or so.

DM: Yeah, I mean, I think Staci pointed out there are only very, very few funds left in that invest directly in Latin America. That is a sign of the investor enthusiasm for the region. You also rightly point out, we talk about Latin America far more than we should because it’s either top or bottom. It’s not mainstream asset class anymore, I’m afraid. There were a much greater number of funds 10, 15 years ago. And, you know, Latin America was a very good place to invest through parts of the 2000, that sort of 2000, 2010 decade and investors would look at that region. But at best, it’s part of a global emerging markets fund and leave it at that for me, I’m afraid.

SW: Okay. Well, we’ll move forward slightly from the charts then. And one thing that we have talked about for what feels like years now on this podcast is elections. So with more than half of the year done, we’ve seen quite a few elections happening already. So first let’s just touch on India’s election. They have come and gone already. Indian equities were top of the charts ahead of technology even. And Juliet, you have been particularly vocal about India in the past. So just give us a little bit on India. Can we expect further growth in India despite the valuations that investors are seeing there?

JSL: Well, yes, as you say, I’m a great believer in India over the long term, and I invested myself there many years ago and just held it through the ups and downs. It’s often the best way.

I looked at it recently at the performance over the past 20 years, and India was just far and away the best-performer. As you say, recent elections, which took the markets by surprise because Modi only narrowly won. And India has been looking a bit expensive, particularly the more domestic small-cap stocks. It’s one of the few areas actually where small-cap stocks have prospered. So we might see a rotation out of them, but India’s in the middle of an IPO boom at the moment. IPOs doubled over the past year there, and it’s taken over from Hong Kong as the centre for IPOs in Asia. And stocks that IPO’d there this year have gone up by an average of 61% in the first day of trading. So there’s no doubt that it’s a thriving market, but I think what you need is a manager who knows and understands the companies there and can sort of avoid those that are looking quite expensive at the moment.

DM: Yeah, I mean, Modi did win, but by far less than was predicted. That did cause an instant market wobble, but only very temporary. I wonder whether there is any relationship at all between electoral cycles and politics, unless a government, wherever it might be that is running on a campaign of doing something that directly affects the stock market or makes it harder for companies to do business.

The UK election, for instance, has been very well telegraphed. We’re going to get a change of government for sure — for sure. I don’t think I’m being super wise predicting that, but what we don’t know is what the next government’s going to look like. We’ve spent a while looking at the last budgets and mini-budgets, talking about what we think might be good.

In fact, we did issue our own little mini-manifesto about three weeks ago, giving whichever government is in power, some suggestions to boost the stock market. Our favoured thing, of course, is compelling UK pension funds to have a certain UK equity exposure, which we think is fairly simple to achieve and absolutely common throughout the developed world. Italy, Australia, America, to name but a few.

So I don’t think unless they’re, you know, wherever it is, the old red herring is healthcare sector with the US, you know, drug costs in the US always have to come down and there’s that sort of cyclical rhetoric that happens. But I think markets broadly are ambivalent to politics unless there is a government going to be formed that is really business unfriendly and hence stock market unfriendly.

SW: So just on the UK then, in particular, because obviously that’s where most of our listeners will be, and the election is next week — is your overarching message, just ‘it’s noise,’ it’s not long-term impacting to UK markets, and you should carry on for the long term?

DM: Look, there’s two ways of looking at this. What does a new government mean for markets? And I think I refer to my previous answer, which is noise.

But more importantly, what does the new government mean for UK savers and investors?

Exactly the people I hope are listening to this Investing on the go podcast! And I think we’re gonna see substantial change to things like capital gains tax not in the manifesto, I believe because I haven’t got that much time to read all the manifestos or the political parties — and I choose not to. But it is very heavily touted in the press that there’s gonna be a change to capital gains. So if 40% taxpayers are gonna see roughly a 12% increase and high rate taxpayers or 45% are gonna see nearly, well 17%, you know, that’s of a real impact. And good, because selling people will have gains. And if you sell before a budget, that might come for a new Labour government where they announce tax changes, you might pay 28% and afterwards you might pay 45%.

So I’m very much hope that the new government doesn’t go out of its way to hurt the savings industry and actually encourages people to save, which further reduces their burden on the state in the longer term. So I think that’s much more concerning and interesting than what the stock market things to a Labour government in the UK. For me, it’s what tax changes will come and will they directly affect savers and investors negatively?

JSL: Yeah, I mean in the UK here, it’s actually we’re actually sort of relatively stable. It’s not like France, which is sort of potentially facing sort of far right, far left. Obviously it does look like a Labour victory. But the potential Labour government in this election does look a lot more business friendly, Liz Truss obviously helped with that showing how disastrous it can be if you frighten markets. So I think once the election is over, the UK might do okay actually if it faces some sort of stability in government and, as Darius says, if the new government doesn’t sort of spook markets with any sort of drastic changes.

SW: Darius, you mentioned the US elections, which is in November and already generating a ton of headlines. Although the early polling suggests that there will be neither a Republican or a Democratic party, overwhelming majority. You mentioned healthcare in the US and how elections can impact healthcare there. So maybe just a few lines on that. I mean we’ve…

DM: What we are hearing from broad US managers and particular healthcare or biotech type managers, they feel that it’s going to be, the healthcare sector’s going to be less of a punching bag in this particular round of US elections, which of course is good.

Other things, I think to be noticed, you have the Inflation Reduction Act, which came in under the current administration, which is to boost infrastructure in the states. I think whoever is the next president is gonna want to spend money on infrastructure. And you know, I believe some of it’s very outdated in different regions. So you can see that type of trend.

Back on healthcare, who knew that if you accidentally discover an obesity drug, your share price would go through the roof. I know we’ve talked, others have talked a lot about the Magnificent Seven really driving US markets last year. Well, I can tell you – because I like to prepare in great detail for these podcasts – Nvidia just this year alone is up a 156%, and that’s not a healthcare stock. But Eli Lilly is, and Eli Lilly and Novo Nordisk are the two companies that have diabetes drugs where the side effect is people lose weight. Well, Eli Lilly’s up 52% this year, and Novo Nordisk, which is a European stock is up 45%. So a couple of really, really big stocks up a lot of really, really driving markets at a headline rate. So, yeah, if you accidentally find an obesity drug, your share price will go up a lot as happened to Lilly’s and Nova;s over the last, not just this year, but last.

SW: Talk about happy accidents. <laugh>

JSL: Yes, indeed. As you say, Staci, there may not be a sort of an overwhelming kind of majority for either party, but actually sort of political impasse is actually quite good for markets because it means that companies know that the no substantial changes can be made. So, yeah, there might be volatility in the run up to the election but I think a sort of lack of majority is actually not a bad thing really.

SW: So with politics and all we’ve talked about also comes geopolitical tensions, which has been prevalent in the first half of the year. How do these tensions influence how you’re looking at markets and the opportunities out there, but also how do you expect them to evolve in the second half of the year?

JSL: Well yeah, I’m this is all rather a sort of depressing topic. I mean, I can’t remember a time when I was so concerned about geopolitics. You know, you’ve got Putin’s war with Ukraine continuing and those in the region are adamant that, you know, if he wins there, he’s gonna move on to other countries. And then you’ve got ongoing tension between China and the US and China’s threat to invade Taiwan. So it feels like a lot is sort of on the knife edge at the moment.

Some things you can you can worry about when you’re investing and others, you, you just have to hope that these things don’t come to pass. If you know, investing in defence, that seems like a fairly safe bet at the moment unfortunately. And I’m the optimistic one on our team!

SW: And just finally, I thought that we would finish with a little crystal ball. So what is your outlook for the second half of 2024?

DM: Yeah, I mean, it’s starting to sound a little repetitive, but the major issue in town is rates and what’s gonna happen to rates. We’ve already touched on what that’s meant for fixed income, but the other way you have to look at it, of course, governments issue these bonds gilts in the UK and Treasuries in the States, and the higher the rates are, the more it costs the governments to physically pay the the interest on them. So I don’t think there’s any doubt both new governments, whether in the States and and UK are going to want lower rates.

Now it’s very easy for people to just anchor around short-termism. And for most of the last, but since the financial crisis really until the beginning of 2022 rates were at or near zero in developed markets and in some places like Central Europe and Germany and Switzerland actually went negative, you know, you would actually lend to a government and get back less than you paid. Well, that doesn’t sound like much of an investment to me, but if you want to spend money as a government, you have to issue your government bonds. Somebody has to buy them, but you then have to pay that interest on them.

So rates for 5.25% in the UK today, I think we might get rates down to sort of 4% over the coming rate cutting cycle, but we’re not going back to 1% and nor do I think it’s healthy for us to go back to 1%. 1% was an emergency rate, and if you look back at the hundreds of years of UK interest rates, that that was the lowest they had ever been. So when we’re talking about a rate cutting cycle, which I believe we should be about to begin, even if it is a little late, I don’t think we’re going, I don’t think we can expect rates to be going back to a half a percent or 1%. They might go as low as two, who knows? This is of course all guesswork and I can guess even better than the central banks seen as they’ve been spectacularly poor at doing it. But my best guess would be that we’re not going back to zero rates, but maybe 3% to 4% or 4% to 5% as a neutral that should give some stimulus to fixed income.

And again, I don’t mean to be repetitive, but you know, what do we like? We like stuff that we think we can buy cheaply that’s still Uk smaller companies, smaller companies broadly in US, in Europe. And other markets that are cheap but very unloved are things like China. That’s not something we directly invest in on the funds, which we advise to, but we do via emerging market funds or Asia funds. But that is a cheap market. US has been propped up by the Magnificent Seven and Nvidia particularly, and Europe, you know, the luxury good stocks and Novo Nordisk have been really strong drivers. So yeah, I would expect moderate returns.

Yes, the geopolitical stuff does look worrying, but again, developed market stock markets haven’t really reacted badly to some of those things they did at the start of the Ukraine war. You get oil price spikes as the Middle Eastern tensions get worse. So oil and energy companies I think are quite interesting. Energy companies make lots of money when oil is $80. If oil goes to hundreds of dollars, they make lots and lots and lots of money.

So that’s the way we try to think as to where: are there niche areas that that we can make good money on? Not a respective of whose in government or respective of the geopolitical tensions, but where you’ve got a better than average chance.

SW: Well, on that cheerful note about the outlook, and I’m gonna say optimistic view for the second half of 2024 we will leave it there to be continued in three months time. So Darius, Juliet, thank you very much for sharing your views once again.

DM: Thanks.

JSL: Thank you.

SW: And if you’d like to get more of the team’s views or to get any manager insights, please visit fund calibre.com and whilst you’re there, please don’t forget to subscribe to the Investing on the Go podcast.