HL Select UK Income Shares - Q3 2024 Review

James Jamieson - Fund Manager

11 November 2024

Market review

Despite relatively modest overall returns in the quarter, stock markets around the world were quite volatile, with the UK’s 2.3% total return making it one of the better performers. The UK saw the Labour Party sweep to power with the expected landslide parliamentary majority, despite earning a lower share of the vote than when they last lost the contest.

Much of the volatility can be put down to inconsistent economic data, especially within the USA. Asian investors appear to have been spooked mid-quarter by data that suggested the US economy was slowing sharply, raising fears that demand for Japanese exports might be hit. An extraordinary few trading sessions followed; Japanese stocks lost over 20% of their value, with other major markets also stumbling. Further data suggested that fears were overdone, leaving markets to quickly recoup much or all of their losses.

US data has continued to be contradictory, but the Federal Reserve kicked off the rate-cutting cycle regardless, with the UK and European central banks quickly falling into line with cuts of their own.

The new UK government quickly set about shredding whatever hopes of a “honeymoon period” it might have had. It seems that Labour sleeves (and the rest of the suit too) have replaced Tory sleaze! The prime minister and his chancellor both talked of difficult economic choices ahead, prompting a widely reported drop in UK consumers’ confidence. Chancellor Rachel Reeves revealed what Labour figures had been hinting at when they talked about needing to take difficult decisions. Labour’s challenge will be to devise affordable policies that can address the challenges of weak productivity growth, worker shortages and a challenging fiscal backdrop.

UK inflation has come back close to target, although a renewed increase in energy prices means that the headline rate is likely to edge back up a bit over the autumn and into winter. The Bank of England appears ready to cut rates further, providing the flow of economic news supports the case.

Within the market investors shied away from uncertainty, and Utilities, along with Consumer Staples, were the best performing sectors. Oil prices fell during the period (the increased intensity of conflict in the Middle East came right at the end of September), causing the Energy sector to underperform. China’s sagging growth led to an economic stimulus package to be announced in Beijing toward the end of the quarter which gave a late boost to commodity producers and luxury goods companies.

Fund review

The fund delivered a return of 1.8%* over the quarter. The biggest contribution to the increase came from our holdings in Consumer stocks, which added around 3% to the fund’s value, with the most significant drags coming from our exposure to Energy, which subtracted 1.4%. Health Care and Financials were also negatives, each subtracting around 0.5% from the fund’s value. Past performance is not a guide to the future.

Total Return (%): Fund v Index v Peers

Stocks review

The winners

Haleon
It was a good quarter for consumer staples businesses in general and Haleon participated in the rally. Concerns over a possible slowdown in the USA led investors to look for defensive sanctuaries and Haleon has been reporting strong operational progress. This left them looking like the right sort of rock for worried investors to hide under. It helps too that the group have made rapid progress in deleveraging, hitting their debt ratio targets a year early. Interestingly, Haleon have bought further into China at a time when many businesses have been looking to exit. Haleon topped up their Chinese JV position by 33% taking them to a majority ownership position.

National Grid
Last quarter we were surprised by an unexpectedly large rights issue that knocked the shares quite sharply. With the capital raise now behind it, investors are now focusing on the organic growth story underpinning Grid. Decarbonisation of the UK’s power generation will require significant new investments to be made, allowing Grid to grow its asset base and hence its revenues and earnings far into the future. This appreciation of the opportunities saw the stock recoup all of the prior quarter’s losses.

British American Tobacco (BATS)
BATS participated in the wider rally underpinning Consumer stocks this quarter. Beyond that the picture is more nuanced. On the upside, the group received authorisation from the FDA, the US regulator, to market six of their Vuse vaping products in the States, recognising the lower risks posed to users by high-quality vaping products.

On the downside though, the US market for tobacco and alternatives remains significantly impacted by a flood of unlicenced vaping products coming from unregulated producers in China and beyond. BATS have pushed out their expected break-even date for their Next Generation Products division as a result. The shares look lowly valued, with a whopping yield, but we are concerned that BATS, and Big Tobacco more widely, are struggling to maintain profitability and market share in the transition from cigarettes to less harmful alternatives.

Cranswick
Cranswick has been one of our most successful investments of the last few years. The company has been investing consistently into building greater capacity and quality control into its business for some time, and these investments are paying off. Trading has been relatively buoyant, allowing forecasts to rise. This policy of consistent organic investment, augmented by occasional bolt-on acquisitions means that Cranswick has a relatively predictable growth pattern which has been increasingly appreciated by the market.

Persimmon
The change of government in July brought in an administration with an overtly supportive stance for the home building sector. Labour’s plans to increase the build-rate to 300,000 homes a year requires far greater output than the industry has been achieving for many years. We have our doubts about the achievability of the target, but the target does not have to be met for the industry to enjoy improved trading, if areas like the planning process can be improved.

The losers

Shell and BP
It is not uncommon to see the major energy firms swing from one end of the table to the other, quarter to quarter and here we are again. The oil price weakened during the quarter, with a rally triggered by increased conflict in the Middle East only beginning at the very end of the period. Shell appeared to have a better operational outcome, looking at their latest quarterly results and we see Shell’s cash returns capacity as better placed than BP’s currently.

AstraZeneca
As one of the very largest stocks in the market and indeed your fund, relatively modest moves in the AstraZeneca price can be notable in their impact. This quarter was one of those periods. Not every clinical trial outcome went the company’s way in the quarter, but they rarely do. We still see AstraZeneca as having a remarkable portfolio of innovative pharmaceuticals and one of the most promising pipelines of potential new drug candidates.

Kainos
The group provide IT services to private and public sector bodies and is also a key Workday partner, selling and installing Workday’s business process management software across Europe and into the USA. Their last update was a curate’s egg. Weakness in sales to commercial IT services clients and an electoral hiatus in public sector spending were clear negatives, although the latter was expected. At the better end of the egg they pointed to margin growth offsetting weaker revenues and signed a big extension to their Workday relationship.

RELX
RELX gave back some of last quarter’s gains. Interim results were fine, with the group making progress in all the key areas. But the results were no better than the market was expecting so with the stock trading at a relatively extended rating, some profit taking was always likely. Indeed we trimmed the position back somewhat during the period because we felt the valuation was a little extended. It remains a core holding though, for the group’s ability to deliver simultaneous growth and free cash flow is undimmed.

The outlook

Wars, interest rates, politics and trade have all been jostling for position in centre-stage in recent months. Events in the Middle East have substantially worsened since the end of Q3, bringing the slump in energy prices to an abrupt halt. The fundamental supply of oil and gas remains one of surplus, but interrupted into actual or potential shortages by the events in Ukraine and the Middle East. We are neither politicians, nor generals, so will not try to predict the outcome, but simply flag that energy prices remain a wild card for inflation, growth and the markets.

America re-elected Donald Trump to the White House. President Trump is keen on lower corporate taxes, but may struggle to deliver them because the US is already highly indebted and running a substantial deficit. President Trump will wield the threat of punitive tariffs against trade partners to extract concessions elsewhere. This is not a new tactic and last time the tariffs imposed were far less substantial than had been threatened. Time will tell.

The inflationary debate remains very much alive and whilst the Fed has made one large cut in rates so far, their next steps are hard to call. Evidence of a slowing US economy was building, then we saw an unexpectedly buoyant set of US employment data, which got the rate hawks squawking once more. It seems clear that the UK and European rate-setters are minded to cut, but only if the data remains supportive. So markets look set to continue with their push-me-pull-you act, rising in anticipation of cuts should data come in weak, but running shy should stronger signals suggest that the Bank of England and the ECB will stay sitting on their hands.

Trade wars look to be on the cards following Donald Trump’s re-election. These are unwelcome and potentially disruptive to economic activity. Tariffs can also be inflationary. There is a clear conflict between central bank’s inflation-targeting and those seeking to erect tariff barriers to trade.

We have seen markets impacted both by the UK budget and the US election result in recent days. This is quite normal and so far, the impacts have been quite limited. Bond yields in the UK and USA have risen as investors reacted to the worsening outlook for public finances became clearer. But the magnitude has so far been modest. The longer-term impact of political change is usually modest. Markets can rise and fall under administrations of any colour. Importantly, the employment outlook in the major economies is still broadly positive. Interest rates still look set to decline further, but perhaps at a slower pace.

October’s Budget gave us the first big insight into how the new Labour Government hopes to balance the books moving forward. Higher corporate taxes formed the centrepiece, but this was a Budget more about steadying the ship, rather than funding radical new policy shifts.

On balance we see the most likely outcome being that this bull market is not over yet, albeit with greater volatility. Like many other bull markets before, it will climb the wall of worry for a while longer until a new and currently unanticipated event knocks it off.

Fund activity

We were thinking that life looked promising for Ascential plc, now shot of its online marketing division. We started building a position and before we reached the full intended size, a takeover bid from Informa sent the stock barreling upwards. We took our profits on the stock and reinvested the monies into Informa, which was already on our radar.

As mentioned, we have been trimming energy positions given the surpluses out there. Clearly a sustained interruption to supply should conflicts worsen will challenge this stance, so we need to keep this under close review. We have also been reducing exposure to the Life Assurers as our work suggests that competition in the bulk annuity space is intensifying, which will pressurise future returns on the supply side. At the same time, on the demand side, corporates are beginning to re-appraise if doing such deals now that their pension deficits are in balance.

At this point we don’t believe that recession is around the corner and are constructive about growth looking forwards. The more confidence we can get, the more likely we are to take a more determinedly pro-cyclical stance in the fund.