It may not be party time, but there are glimmers of hope

The narrative around cost of living pressures has been unrelenting over the last 2 months – dominating the news and political debate. It has also led to a material derating of financials and domestic cyclicals in the UK Equity Market. Our recent article (see here) highlighted the valuation distortions across the market but also the absolute valuation of a number of the stocks caught up in this trend. We concluded many of the valuations are absurdly low.

As we have seen clients and met companies over the last 3 months, we have consistently highlighted three mitigants to the inflationary cost pressures households are seeing. We are not aiming to debase the fact that for many families the current economic climate has led to difficult times merely that the market has got carried away with this narrative and mispriced stocks as a result.

These three mitigants are:

  1. Strong growth in wages, which we expect to grow by c. 5-6% in 2022 – labour markets remain strong with more job vacancies than people looking for work and with widespread labour shortages this is likely to remain the case into 2023

  2. Excess savings of £200-250bn have been built up across the Covid period, which we think will act as a buffer for certain households as we go through H2 2022 and H1 2023. These two items are material offsets to energy and other cost pressures

  3. The possibility that the government would come forward and inject another ‘offset’ into the mix. This was not discounted but happened on Thursday, 26 May when Chancellor Rishi Sunak announced a c. £15bn injection into households. This was significantly more than we expected and importantly is directed at lower earnings groups, which are less likely to have the excess saving and where the inflationary discomfort is felt more keenly.

The combination of wage growth and Sunak’s move means average household free cash flow, available for discretionary spending, will fall only slightly this year, with the excess savings noted above potentially more than offsetting this.

We therefore believe that the consensus we see in valuations is too negative. This was seen in market action yesterday with sterling rising and domestic stocks taking a good step off the bottom.

Sources for all data: JOHCM/Bloomberg (unless otherwise stated); company data from company accounts.

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