This could be the catalyst for ‘unloved’ UK market in 2024

Alex Wright, fund manager of Fidelity Special Values (LSE:FSV), points out that for his strategy the three-year period (to the end of September 2023) was one of the best-ever performance periods. However, he says that while the UK market fared well over this period, many investors haven’t noticed and have been neglecting the region. With valuations attractive and lower than historical averages, Wright is hopeful the UK will lose its ‘unloved’ label in 2024. However, for this to happen, he thinks something else needs to play out – find out what in this interview.

Wright also tells ii’s Collectives Editor Kyle Caldwell how the wider macroeconomic environment, including interest rate rises, influences his investment decision-making. He also names a reason for investors to be cautious and a reason for them to be optimistic for the year ahead.

Fidelity Special Values is a member of interactive investor’s Super 60 list of fund ideas.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio I have with me Alex Wright, manager of the Fidelity Special Values investment trust. Alex, thanks for coming in today.

Alex Wright, manager of Fidelity Special Values investment trust: Thanks for having me.

Kyle Caldwell: As we head into 2024, there's a lot of pessimism around the UK equity market. Some commentators are forecasting that the economy will enter a recession, although they were also predicting that this time last year. What are your thoughts, and could you name one reason to be optimistic for the year ahead and one reason to be cautious?

Alex Wright: I think the reason to be cautious is obvious, and it's that recession point. I think you're right, 12 months ago, most people thought we would be in a recession today in 2023, but we haven't so far. I think the big danger for 2024 is more where people aren't looking. People have become much more optimistic about the US economy as we've gone through 2023 as it's grown surprisingly strongly, about 3% GDP growth. But when you just look at why that's occurred, there is the risk that the US goes into a recession in 2024 and because the US is the world's biggest economy by some distance, that clearly has a big effect on the rest of the global economy and also the UK stock market. Given that after the UK, the US is the biggest area.

I think the good news is that when you think about what happens to earnings in a recession, you could typically see sort of 20% to 40% earnings declines. Now, I think that would be a big deal for the US market, which is trading on close to 20 times earnings. So, you could see quite a big drawdown in that market. The UK market's on about 10 times earnings and indeed the trust is on about 7.5 times earnings. So, maybe those earnings estimates are wrong by up to 30% or 40%. But you would still, for the market, probably only get back to average earnings levels. So, 14 times is the average multiple for the UK market and the trust would still be well below that.

So, I think even if you have a recession, there's a possibility that the UK market could make absolute headroom through that, particularly as people look to that being a clearing event, and therefore may even be willing to pay a higher-than-average price-to-earnings (P/E) as you exit a recession and generally see a recovery in earnings.

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Kyle Caldwell: For a long time now, the UK market has been out of favour. You just touched on valuations. Do you think that’s the main catalyst that will finally get investors to return to the UK market?

Alex Wright: I think the big deal has been that because of the outsized performance of the US market, it really has sucked capital away from most other capital markets. And the UK being a very large market was still the largest stock market in Europe, despite the fact that the number of companies has been shrinking, [it] has been definitely in the crosshairs of that.

So, if we do see a correction in the US market, I think that could be the catalyst for a UK re-rating as people think a lot more about valuations rather than about the momentum that has really been driving stock markets over the last couple of years.

Kyle Caldwell: The value style of investing, which you follow, tends to perform well in a rising interest rate environment. So, two years on from those interest rates in the UK starting to edge upwards, how would you assess the performance of Fidelity Special Values since interest rates have been rising?

Alex Wright: If you look at the performance of the trust, and we're looking back here to the three-year performance to the end of September, actually this has been one of the best-ever three-year performance periods, both relative and absolute. And indeed, we've done better than the Nasdaq over this point, so, it's really interesting.

A lot of people are still talking about UK market underperformance. And it is true that the UK market underperformed for five straight years from 2016 to 2021. But we are now three years into an outperformance cycle and people don't really seem to have noticed. Most people are still sort of saying 'when's the UK market going to stop underperforming?' It already has. It's just people aren't actually paying attention and are still withdrawing money from the market, which to me is quite a surprise after this big comeback.

Kyle Caldwell: So, over that three-year period you just mentioned, what have been the main drivers of performance? Are there any particular companies or sectors that stand out?

Alex Wright: It's been quite a broad-based performance. So, obviously quite a lot has happened through this three years. If you think back to September 2020, this was before the discovery of the vaccine in Covid. So, everyone was still at home with various forms of lockdown. And clearly that was very painful for most old-world economy sectors, including a lot of stocks that the company has big holdings in. So, Photo-Me passports, Ryanair, some of the banks, consumer-facing companies and those have had a very strong run since then.

Also the inflation that's been generated has benefited commodity sectors. And so again, our oil holdings have done well. And then particularly the financial sector has done well as interest rates have normalised. So, those would be some of the key generators of performance over the last three years.

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Kyle Caldwell: And you mentioned that for the trust there's been a broad set of winners. With the UK market in general, particularly last year, there was a narrow set of winners. I think if you didn't have exposure to oil or mining, you potentially wouldn't have done very well. Have we seen a broader set of winners this year and going forward, will that continue?

Alex Wright: Again, 2023, it's generally been the large-caps which have outperformed. It’s been more difficult for the smaller companies in the broader market, particularly because those areas are more cyclical and the oil prices remain very high. So, that has been a key area that's outperformed. I would think that going forwards, now that you've seen valuation ratios compress, and particularly if we do get the other side of a recession over the next 12 months, you would tend to see that being more beneficial to the more cyclical, more mid- and small-cap areas.

Kyle Caldwell: You're a bottom-up stock picking investor, but I wanted to ask you a question about the macro anyway, which is what are your views on where interest rates are heading? Are they going to be higher for longer?

Alex Wright: Definitely when you're investing in companies, you need to think about what the macro environment could be like because that will influence what the earnings of the companies are. We need to be aware of the range of outcomes and what that would mean for the company and particularly avoid companies that if the macro is worse than is expected, are going to have financial problems. So, that's something we really bear in mind.

In terms of calling a point estimate, particularly over the shorter term or even over a 12-month view on interest rates or inflation, that's incredibly hard to do. So, we try and avoid doing that and instead think about very long-term ranges. I think that's really important because what people think is the very long term is maybe, oh, what's happened over the last 10 years. Now, over the last 10 years, interest rates have broadly been between 0% and 1%, and inflation has generally been between 0% and 2%. And so, a lot of people anchor on that as that normal period. But, if you look over 100 years, when we have the history, that is an incredibly unusual thing to happen, that you have had periods of no inflation or no interest rates, but they tend to be very short-lived after recessions. Normal interest rates are much more like the 5% we have today, and normal inflation is more like 3% or 4%.

I don't have a particular view on exactly what's going to play out. I think the fact that a lot of people are still anchoring to a world that's really unusual means that I would be betting on the upside compared to most expectations on both interest rates and inflation, because that is the more normal picture through time.

Kyle Caldwell: Finally, do you have skin in the game?

Alex Wright: Yes. I invest both in the investment trust, which will be my larger holding, and also the open-ended fund Fidelity Special Situations, which we run.

Kyle Caldwell: Great to hear and thank you very much for your time, Alex.

Alex Wright: Thank you.

Kyle Caldwell: That's it for this episode of our Insider Interview. Please like, comment and do hit the subscribe button and hopefully I'll see you again.