Banking on Britain
Neil Woodford is encouraged by improving trends in the UK economy and signs that the banking sector is returning to health.
Since the UK’s referendum last year, there have been plenty of prophets of doom warning that the UK economy and UK Plc was in for a tough time.
Yet aside of a sharp fall in sterling and rise in inflation, leading indicators have in fact offered plenty of encouragement, even though the shape of Brexit remains far from clear.
“The UK economy is actually performing pretty well,” says Neil Woodford of Woodford Investment Managers. “It was in good shape before the referendum, but it grew even quicker in the second half of 2016 than it did in the first half. Also, the unemployment rate continues to go down – it’s now at a record low for the last 40 years.”
Woodford sees other tailwinds in play too, among them a potential fall in the budget deficit by £20 billion, and a trade deficit that has shrunk dramatically because of the fall in sterling. Both export performance and business investment have improved in the second half of last year.
Yet some investors and economists are concerned about the rise in inflation, a trend largely attributable to the fall in sterling after the referendum. In Woodford’s view, however, that knock-on effect has an end-date.
“Inflation has increased as a result of the Brexit vote, but once that effect washes through – and we’re starting to see that now in the annualised figures – in my view, inflation will return from where it came, which means to around 0.5%. It’s worth remembering that, over the period in which we have had an independent central bank, inflation has been below its target of 2% for much longer than it has been above that level.”
If anything, he points out that the challenge will not be inflation but deflation, largely due to low productivity and an ageing demographic profile. But that is a policy challenge – Woodford believes that the underlying economic momentum remains very healthy.
One of the places that is most apparent is in the banking sector. Woodford’s high profile as an investor stems, of course, from his long-term success, and much of that has been founded on his willingness to go against the consensus. Alongside his avoidance of the tech bubble, perhaps the most dramatic episode that built his reputation was his decision to pull out of UK banks in 2002, worried by how far they had extended their balance sheets. That move, of course, proved to be very prescient indeed.
Yet after years away, he has finally gone back in, building a significant position in Lloyds.
“I was worried about the excesses in the banking system, the leverage on the banks’ balance sheets and the inadequacy of their loss-absorbing capital,” he says. “Moreover, regulation was very light in that period. I own banks now because I believe they are now largely repaired – as evidenced by the pick-up in lending. Throughout the financial crisis, I watched what the banks were doing rather than what they were saying, and they were not lending to the economy.”
Woodford views the simple fact of banks lending again as an “important sign” that their balance sheets are largely repaired and that they hold adequate capital. They now have more deposits than loans. Woodford maintains that when credit is functioning more normally in an economy, then the economy as a whole can perform better.
“How banks are behaving is a good measure of whether they are healthy or not,” he says. “These days, they arguably have too much capital, not too little. I believe the UK banks are now in a position to start rewarding shareholders, as they are now able to generate a substantial surplus.”
Woodford Investment Management is a fund manager for St. James’s Place.
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The opinions expressed are those of Neil Woodford of Woodford Investment Management and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management