Market Commentary – UK Small Cap Team, August 2022
By Dr Paul Jourdan
TB Amati UK Smaller Companies Fund
The relief rally for equities in July proved short lived in August. Estimates for inflation rose dramatically during the month as European gas prices surged to record highs. Russia cut supplies of gas through Nordstream One to 20% of capacity at a point when Germany and France were refilling gas storage in preparation for winter. The situation was made worse by a heat wave which meant that more than half of French nuclear reactors were shut down, mostly for maintenance, but in some cases because the river waters they were using for cooling became too warm. Nordstream One is now shut and is unlikely to re-open over the next few months. The risks to power prices over the winter and throughout next year remains high, and across Europe governments are working on ways to mitigate this both through subsidies and new price mechanisms being agreed with power producers, and price caps on Russian energy exports. The knock-on impact of the energy crisis is severe. Higher estimates for inflation have shaken Government bond markets profoundly. In June 2020 the UK Government could borrow for 30 years at a rate of 0.6%, the rate at end of July 2022 was 2.4% and at the end of August it was 3.1%. This looks like a major reversal of the long-term trend in falling UK Government bond yields, and the most dramatic rise in the last 30 years. Almost the first act of the new Liz Truss government has been to shield consumers and businesses from the impact of soaring energy costs. This was essential to avoid a disaster, but the scale of spending will echo that required by the pandemic. The difference now is that borrowing will be much more expensive and, with inflation running into double digits, using quantitative easing to lower bond yields would add fuel to the inflationary fire so isn’t likely to be an option. Meanwhile the recession being threatened by the energy crisis, not to mention higher base rates, may cause government revenues to fall below budget this year. Concerns over the level of public sector net debt in the UK and in Western economies more generally, will continue to worry investors and be reflected in currency, interest rate expectations and stock valuations, albeit that the relief brought about by the energy price guarantee will allow strong businesses scope to continue to develop.
August was a difficult month for the fund, which fell 6.6% whilst the benchmark index fell by 3.9%. The top contributor was OSB (formerly, OneSavings Bank), a bank focused on mortgage lending for professional buy-to-let landlords, which published strong interim results. Other positive contributions came from FRP Advisory, an insolvency practitioner, which continuing to rise following strong results at the end of July; and the energy stocks, Energean, Touchstone and Petrotal, each of which rallied following falls in the prior few months. Stocks which had rallied in July, rolled over in August, including TT Electronics, Vistry, I3 Energy, Indivior and Craneware. XP Power produced disappointing results at the start of the month, with strong order intake, but with revenue growth constrained by component shortages as delivery times lengthened again. Retailers came under further selling pressure, amidst worries over high gas prices, and Cake Box, a franchising business making egg free cakes, downgraded profit expectations by around 25% due to higher costs both of staff, energy and ingredients such as cream.
Prior to the market falls at the end of the month among the holdings we reduced were CMC Markets, DFS, Cake Box and Spirent. We opened a new position in Diversified Energy and added to Gamma Communications, Polar Capital and Serica. We added to Saietta, the electric drivetrain engineering technology group, which raised £23m to fund a joint development agreement with ConMet, the dominant US manufacturer of wheel hubs for commercial vehicles. The agreement covers the development of two products, with Saietta motors fitting inside these wheel hubs. We see this as a hugely significant deal for the company.
Amati AIM VCT
The relief rally for equities in July proved short lived in August. Estimates for inflation rose dramatically during the month as European gas prices surged to record highs. Russia cut supplies of gas through Nordstream One to 20% of capacity at a point when Germany and France were refilling gas storage in preparation for winter. The situation was made worse by a heat wave which meant that more than half of French nuclear reactors were shut down, mostly for maintenance, but in some cases because the river waters they were using for cooling became too warm. Nordstream One is now shut and is unlikely to re-open over the next few months. The risks to power prices over the winter and throughout next year remains high, and across Europe governments are working on ways to mitigate this both through subsidies and new price mechanisms being agreed with power producers, and price caps on Russian energy exports. The knock-on impact of the energy crisis is severe. Higher estimates for inflation have shaken Government bond markets profoundly. In June 2020 the UK Government could borrow for 30 years at a rate of 0.6%, the rate at end of July 2022 was 2.4% and at the end of August it was 3.1%. This looks like a major reversal of the long-term trend in falling UK Government bond yields, and the most dramatic rise in the last 30 years. Almost the first act of the new Liz Truss government has been to shield consumers and businesses from the impact of soaring energy costs. This was essential to avoid a disaster, but the scale of spending will echo that required by the pandemic. The difference now is that borrowing will be much more expensive and, with inflation running into double digits, using quantitative easing to lower bond yields would add fuel to the inflationary fire so isn’t likely to be an option. Meanwhile the recession being threatened by the energy crisis, not to mention higher base rates, may cause government revenues to fall below budget this year. Concerns over the level of public sector net debt in the UK and in Western economies more generally, will continue to worry investors and be reflected in currency, interest rate expectations and stock valuations, albeit that the relief brought about by the energy price guarantee will allow strong businesses scope to continue to develop.
The NAV (Net Asset Value) total return bucked the general downward drift of the market in August, rising by 1.5% whilst the Numis Alternative Markets Index fell by 3.8%. The biggest factor in this was the rally in Polarean, the lung imaging company bringing an innovative technology to market, as it approaches the date for FDA (Food & Drug Administration) approval following the submission of additional data earlier this year. Additionally, Diurnal, the specialist pharmaceutical company treating patients with chronic hormonal diseases, which had suffered from slow adoption of its products, received a bid approach at the end of the month, reversing some of the damage from share price falls earlier this year and providing an acceptable exit from this under-performing position. Beyond this there were rallies from Water Intelligence, and Velocys. Northcoders, provider of training programmes for software coding in which the VCT invested last year, rallied strongly after winning a large new government contract, underpinning continued strong growth. Saietta, the electric drivetrain engineering technology group, also rallied as it raised £23m to fund a joint development agreement with ConMet, the dominant US manufacturer of wheel hubs for commercial vehicles. The agreement covers the development of two products, with Saietta motors fitting inside these wheel hubs. We see this as a hugely significant deal for the company. On the negative side, a wide range of holdings fell back along with overall negative moves in the market, including Learning Technologies, GB Group, Craneware, and Frontier Developments.
There were no significant new investments or sales during the month.