Woodford: UK banks can heal the economy

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My investment approach often appears contrarian, although I do not go out of my way to do the opposite to the market.

Often, however, I find myself drawn to areas of the stockmarket that have fallen out of favour – investor antipathy towards certain stocks or sectors becomes embedded in valuations and it is that undervaluation that sparks my interest.

Recently, I have seen value emerging in parts of the market that have fallen out of favour, in part, as a result of last year’s surprise outcome of the EU referendum. In my view, the share prices of many UK domestic businesses now imply an imminent collapse in UK economic growth rates. I simply do not see that outcome as likely – indeed, the outlook for the UK economy is improving, not deteriorating.

At the heart of this more positive view on the domestic economy is the UK banking system, which now appears, at last, to be substantially healed. Throughout the financial crisis and its prolonged aftermath, I have been more interested in what the banks are doing, rather than what they are saying, and looking for evidence that the banks were beginning to lend again before feeling more confident that the UK banks had substantially completed their healing process.

That pick-up in lending has been evident since late 2016 – I now see a banking system that is in much better shape, with substantially more capital than at any time in recent history and one that clearly now feels confident enough to start extending credit to the wider economy again. This has positive implications for the UK economic growth outlook and also represents an opportunity to revisit the investment case for UK retail banking.

Despite the rehabilitation progress that the banks have made, share prices remain surprisingly close to the lows that coincided with the depths of the financial crisis in early 2009. Share prices tend to trade below book value, suggesting that the stockmarket has yet to acknowledge the transformation of UK banks’ prospects that is now well underway.

Of course, not all corners of the UK economy are as well placed to benefit from the benign outlook that I now foresee, but one that stands out as particularly well poised is the construction sector. Here, I see an industry with positive fundamental dynamics and, with housing identified by both major parties as a key campaigning topic in the recent election, a long-term opportunity which is underpinned by the public sector.

Fixing the UK’s “broken” housing market inevitably means building many more homes and although some have concerns about property valuations, from an affordability perspective, with interest rates at record lows, mortgage repayments represent a much smaller part of take-home pay than is normally the case.

Importantly, this investment case is about volume, not price – higher interest rates or a material price correction could undermine it, but I do not expect either to prevail. Indeed, modest house price increases are possible across much of the country.

I have been asked several times recently what implications this increasingly benign view of the UK’s economic prospects has on the outlook for domestic inflation and interest rates. In short, the answer is very little. I would not describe myself as a raging bull on the UK economy, but I do have a more upbeat view of its prospects than an increasingly downbeat consensus. In reality, this means decent growth but not the sort of rampant conditions that would squeeze inflation higher or require the Bank of England to raise interest rates to cool economic activity.

It would be wrong to interpret the recent return of inflation in the UK as enduring,  it is primarily a function of the post-Brexit vote decline in sterling. Once that washes through the system, the UK will again prove as susceptible to the deflationary forces that have continued to suppress inflation elsewhere around the world for years now. Much of what I try to do as a fund manager is aimed towards positioning the portfolios I manage to exploit differences between what I believe and what has become baked into valuations.

It would be wrong to interpret the recent return of inflation in the UK as enduring,  it is primarily a function of the post-Brexit vote decline in sterling.

The market has become too downbeat about the long-term prospects for the UK economy and, at the same time, too optimistic about the outlook for the global economy. Really, these are two sides of the same coin and although the differences between my expectations and that of the market consensus may appear quite modest, their impact on the valuations of individual stocks can be profound.

With that in mind, I have been keen to take advantage of a contrarian opportunity to invest in undervalued, high-quality, domestic, cyclical businesses, with a view to enjoying their attractive yields, sustainably growing dividends and, over time, as the market recognises that these businesses are not as challenged by the economic outlook as share prices would imply, a return to more appropriately attractive valuation territory.

Neil Woodford is head of investment at Woodford Investment Management