Whisper it quietly but the UK economy has been showing signs of resiliency in recent months, as it continues to fight off a series of short- and long-term headwinds which dominate the news.
Nominal growth of 0.2% in the second quarter of 2023 beat consensus expectations, with services, construction and industrial production all generating positive growth. Meanwhile, the International Monetary Fund has also reversed its view that the economy would enter recession this year.
Part of this is down to the £200bn of savings built up by the resilient UK consumer during the pandemic. This foresight seems incredibly shrewd, given the higher prices now prevalent in the UK economy. Remember, the services sector accounts for around 80% of UK GDP.
The UK has been out of favour since rates were cut to record lows in the wake of the global financial crisis
But with this resiliency comes sticky inflation, principally due to wage demands and low levels of unemployment in the UK. The Bank of England is hopeful inflation will fall to around 5% by the end of this year and reach 2% by early 2025.
What I’ve tried to convey is a balanced picture of the economy – but markets do not reflect this. The truth is the UK has been out of favour since rates were cut to record lows in the wake of the global financial crisis.
In the past 15 years, the FTSE All Share has returned 148%, while the S&P – which has more of a growth bias, including a host of tech behemoths – has risen 527%.
Brexit was a further catalyst for concern. It seems that from the moment the term was coined, investors have been voting with their feet, with over £33bn withdrawn between 2016 and 2022 (including almost £12bn in 2022 alone, when the FTSE 100 was one of the better performing global indices).
UK equities have not been this cheap – both on an historical basis and relative basis – since the global financial crisis
However, when I look at the positives behind investing in UK PLC from here, it really is hard to ignore the compelling valuations.
Prior to 2015, UK markets traded slightly higher than the eurozone and only at about a 10% discount to the US. In the five years after that point, the valuation gap expanded, with UK stocks closer to a 45-50% discount compared to the US.
Figures from Franklin Templeton shows UK equities have not been this cheap – both on an historical basis and relative basis (PE relative to the MSCI World) – since the global financial crisis.
City of London Investment Trust manager Job Curtis says the domination of the World Index by American companies – specifically the tech giants, like Microsoft and Amazon – is a major reason for this valuation discrepancy. However, he says there are elements beyond this, which are down to poor sentiment.
Whatever we feel about Brexit in the UK, the global view has not been particularly positive
“Take Shell as an example and compare it with Exxon Mobil Corporation, which is the big American oil company. The discount of Shell is more than 20%,” he says. “It’s the same with British American Tobacco and Philip Morris as well. Whatever we feel about Brexit in the UK, the global view has not been particularly positive, and this has affected people’s attitudes.”
The UK is also one of the global leaders when it comes to innovation, with some £47bn of research and development performed on UK business in 2021 alone.
This brings me to UK small caps, which always seems to come out of any crisis better than ever. The hope is that with inflation starting to fall, sentiment towards UK smaller companies will start to reverse.
Even with this poor sentiment, the FTSE 100 has a degree of protection due to the fact around 74% of its revenues are garnered overseas. The FTSE 250 also derives over half of its sales overseas. Ultimately, the UK market is not beholden to the UK economy, with a large number of companies having a global footprint.
The UK is tiptoeing its way back into the fold of fashionable markets to be seen around town
The big question is what catalyst, if any, will facilitate a change in sentiment within UK equities? I’ve often felt that sometimes valuations alone are a catalyst, and, to me, UK equities do look attractive from this point on a long-term horizon.
Fidelity Special Values manager Alex Wright says merger and acquisition activity has been unprecedented in recent years, driven primarily by private equity and US-based corporates, which are willing to pay prices based on US valuations.
While rising rates have limited the ability of private equity businesses to borrow, these attractive valuations mean we can still expect activity for UK businesses.
The other catalysts are longer-term in nature. The first is the wider move from quantitative easing (QE) to quantitative tightening – meaning growth as the only game in town in the accommodative QE world is now over.
While it’s hard to say what will finally turn the wheel of fortunes for UK equities, I would not be surprised to see things move fast
Artemis Income co-manager Andy Shenton says this suggests the UK is tiptoeing its way back into the fold of fashionable markets to be seen around town and that the case for a more balanced portfolio is valid. He believes factors such as inherent quality and long-term investment in innovation will serve UK equities well in a sustained period of higher, normalised interest rates.
I also want to highlight the Mansion House plans to reinvigorate the UK as a destination for growth company investment. This could be a potential turnaround from the regulatory changes which disincentivised pension and insurance funds from holding equities – to the point where institutional investors now own less than 5% of the UK stock market.
While it is hard to say what will finally turn the wheel of fortunes for UK equities, I would not be surprised to see things move fast. So exposure at these attractive valuations makes sense from a long-term perspective, despite the likely bumps in the road.
Investors may want to consider a couple of pure stock pickers like Abrdn UK Mid-Cap Equity or the IFSL Marlborough Multi-Cap Growth fund, while those looking to income might consider Rathbone Income.
Darius McDermott is managing director at Chelsea Financial Services & FundCalibre
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