Alex Wright, portfolio manager of Fidelity Special Values PLC (LON:FSV), reflects on the challenges facing investors in domestic equities. Despite continued uncertainty, he highlights why UK equities offer attractive buying opportunities and outlines why he expects value to continue to outperform in the current market environment.

Key points

• While the near-term outlook is uncertain, we believe valuation levels and the large divergence in performance between different parts of the market create good opportunities for attractive returns from UK stocks.
• Many businesses and investors have yet to adjust to the new reality of higher interest rates. This has both positive and negative implications for companies but should favour value investing and UK equities. 
• We are proceeding cautiously and gearing in the portfolio remains low, leaving us with plenty of dry powder to reinvest should opportunities arise. Prior periods of uncertainty have in retrospect turned out to be great buying opportunities.

There is clearly a lot of economic and geopolitical uncertainty globally, as economies are grappling with levels of inflation not seen for several decades. Most indicators point to a slowdown or recession, particularly for the consumer as inflation and rising interest rates take their toll. The unpredictable demand picture combined with continued supply chain pressures are adding to the volatility, and we have started to see that emerge in company earnings.

Whilst this sounds relatively bleak, many of the most affected areas of the market have sold off heavily and some stocks are starting to look interesting. After years of being relatively unloved, the UK market started 2022 looking like good value, and now looks even cheaper. While the near-term outlook is uncertain, we believe these valuation levels and the large divergence in performance between different parts of the market create good opportunities for attractive returns from UK stocks in the next three to five years. In our opinion, the UK market with its higher dividends offers a better prospective return than from many other asset classes, including global equities.

What could surprise markets in 2023?

Many businesses and investors have yet to adjust to the new reality of higher interest rates and bond yields. Whilst some market commentators think this higher cost of finance will fade away, we are more sceptical. The current market environment of higher rates and stickier inflation is more representative of the longer-term pattern seen prior to the Global Financial Crisis.

This has implications for companies that are highly levered and have re-financing needs and will be reflected in a lower availability of capital and significantly higher interest costs. Business models that rely on a lot of debt such as infrastructure owners and developers, utilities and property developers are likely to struggle in this environment. Clearly housebuilders are another area that have been badly impacted by the increased cost of finance for their customers, even if not highly leveraged themselves. From a valuation perspective, history suggests that value tends to outperform in a higher rate environment given higher discount rates and a reversion to mean, which should also favour UK equities.

Positioning for what lies ahead in 2023

A rising rate environment has the potential to be transformational for banks, and indeed, profits for banks such as NatWest could double next year, which is a compelling story in an environment where markets are seeing earnings downgrades and fears of more. The backdrop is also positive for life insurers, whose earnings have proved resilient during the pandemic and should benefit from an acceleration in the pace of pension fund re-risking.

Companies that can hold up well in a recessionary environment should prove good investments. The likes of government outsourcing business Serco or tobacco firm Imperial Brands, two of our largest holdings, should be relatively unaffected by an economic downturn. Conversely, we are wary of highly leveraged companies, and have negligible exposure to real estate and limited exposure to utilities. We have also meaningfully trimmed our UK housing exposure on concerns momentum in the residential market will slow and consumer facing stocks given the cost-of-living crisis.

Over the past decade that we have run this strategy, there have been similar periods of heightened uncertainty such as around Brexit, the election of Donald Trump and the Covid pandemic. It is environments like these that throw up the best investment opportunities as market participants get overly preoccupied by anticipated headwinds. So, we aim to stay agile and will continue to be on the lookout for new opportunities. It is likely there will be forced sellers, especially if the fund flows picture does not improve and as institutional investors look to rebalance their portfolios.

Periods of extreme uncertainty have in retrospect turned out to be great buying opportunities that have allowed us to pick up stock specific stories that had been overlooked in the general panic. However, we are proceeding cautiously and gearing in the portfolio remains low, leaving us with plenty of dry powder to reinvest should opportunities arise. The funds are broadly diversified with over 100 holdings spread across market caps and sectors, with exposure to both cyclical and defensive businesses, which seems prudent given the level of macroeconomic uncertainty.

Fidelity Special Values PLC (LON:FSV) aims to seek out underappreciated companies primarily listed in the UK and is an actively managed contrarian Investment Trust that thrives on volatility and uncertainty. Supported by an extensive research team, they look to invest in out-of-favour companies, having spotted potential triggers for positive change they believe have been missed by others.