Why large-cap multinationals offer protection from growing volatility
Among an array of macro uncertainties, such as trade wars, protectionism, Brexit and political uncertainty, one of the principal reasons for spikes in equity market volatility this year has been liquidity. Central banks have provided unprecedented levels of liquidity to the market since the Global Financial Crisis, which has created significant distortions in valuations.
Ten years on, as central banks move to tighten monetary policy, the process of liquidity withdrawal and interest rate ‘normalisation' is reigniting equity market volatility. This situation has been exacerbated by international investors' underweight position in UK equities leading to a lack of supporting inflows, and a ‘negative momentum' effect from the rise of passive and quant-based investing.
What we have learnt about liquidity over the past decade
Equity valuations are determined in part by future growth rates, but also by the rate at which that future growth is ‘discounted' back to present value. Rising interest rates and yields lead to higher discount rates that reduce the present value of future earnings and cashflows. We believe that investors should be careful of crowded trades in illiquid stocks, that have hefty growth assumptions, and where valuations leave little room for disappointment.
In the UK, this is particularly prevalent in the small- and mid-cap space where a number of funds have significant exposure. As a result, we prefer large, liquid, and high- quality, multinational companies with globally diversified revenue streams, sustainable business and financial models, reliable cashflow and dividend growth drivers, strong balance sheets, and lower sensitivity to the economic and market cycle.
Prepare for 'strange' occurrences as liquidityconcerns overlooked
These companies are best placed to weather market volatility and liquidity concerns, as well as political and economic challenges and risks to sterling. Smaller companies will not be immune from more difficult market conditions and illiquidity.
Opportunities still exist in smaller companies with proven business models whose valuations already price in the risks of a UK recession, as well as smaller companies that have demonstrated quality characteristics through previous cycles, or have niche products, services or business models that provide an element of protection from general market volatility. In all cases though, careful stock selection will be required.
Simon Brazier is portfolio manager of the Investec UK Alpha fund
Bull Points
- The UK has many high-quality, globally diversified businesses that are well placed for current challenging markets
- Volatility creates buying opportunities for active long-term stockpickers
Bear Points
- Liquidity withdrawal and tightening monetary policy
- Brexit-induced volatility in sterling and UK stocks
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