The UK: the start of a fightback?

The UK economy flatlined in the third quarter of this year, but defied economists’ expectations and side-stepped recession once again*. Inflation is also falling, dropping below 5% in October for the first time since late 2021**. While the UK economy may not be out of the doldrums yet, it may have finally stopped getting worse. For investors, the question is whether it reignites any enthusiasm for the UK stock markets.

The UK market is out of favour on most measures. Research from Allianz Global Investors shows that investors pay approximately one pound for every £10 of profit generated in the UK, while on Wall Street they have to stump up $20 for every dollar***. The MSCI UK index trades on an aggregate price to earnings ratio of 11.1x, compared to 18.7x for the MSCI World****. It is cheap and unloved.

This unpopularity is usually attributed to a confluence of factors, including the dominance of unfashionable ‘old school’ industries, such as mining, oil and gas or banks, Brexit, some tricky politics and a lacklustre economy. Many of these factors have continued to weigh on sentiment even as UK companies have performed well.

Nevertheless, Alex Wright, manager of Fidelity Special Values, suggests that the gloom around the UK market may have been overplayed. He points out that the FTSE All Share has actually performed in line with the Nasdaq since 2020 – a combination of real weakness from the US technology giants in 2022 and the strength of the mining, commodities and banking sectors in the UK market. More importantly, he adds, this strength has come from earnings upgrades rather than any revision to valuations – the market remains as cheap as ever.

Will a strong performance from the UK economy draw investors back?

UK large caps draw their revenues from across the globe and their fortunes are only minimally tied to the UK economy. An improvement in the UK economy is therefore likely to do little for earnings, which are more dependent on global growth. However, it may help improve sentiment towards the UK market, and lure back the domestic investors that have abandoned it.

For small and mid caps, there may be a stronger relationship. Alex Game, assistant manager of the Unicorn UK Smaller Companies fund says inflation has tended to act as a drag on smaller company performance. He adds: “Smaller companies always tend to underperform in those environments and historically, have outperformed very significantly as inflation has rolled over. This backs up what our investee companies have been saying – supply chain problems are easing, input costs are easing.*****”

Alex Game echoes many UK smaller companies managers in saying that share prices look increasingly out of touch with the operational performance of companies. He adds: “We have been really encouraged by the underlying trading performance that companies are posting at the moment. The vast majority of companies are delivering in line or ahead of market expectations. When you consider the backdrop, they’re still growing posting revenue growth, profit growth and cash growth, often supported by long-term structural trends. Yet valuation-wise, they’re being priced for a crisis.”

Scott McKenzie, co-manager of the WS Amati UK Listed Smaller Companies fund, tells us more about the pressures and opportunities for UK smaller companies in our recent interview.

Is now the right time?

By all the laws of investment, this should be a good moment to re-examine UK equities. Valuations are low, the sector is deeply unfashionable, selling pressure has been relentless.

The UK All Companies sector has been the worst-selling net retail sector in six out of the past ten years^. It has seen net outflows every single month for the past year^. The same is true for the UK Smaller Companies sector^. In total we’ve seen some £44bn of net retail outflows from UK equities since the start of 2016 alone^. Having seen this level of selling, it won’t take many buyers to trigger a significant rally.

However, there is a question over where those buyers will come from. They probably won’t come from global asset allocators. The UK is no longer a significant part of any global index. Scott McKenzie told us recently, “The UK is only about 4% of the MSCI World Index, it’s gone down considerably over the past 10, 20 years.” In fact, its whole market capitalisation is less than that of Apple^^.

Global investors don’t need to have a view. In this way, it may be cheap, there may be great companies delivering great earnings, but – like a tree falling in the forest – does it count if there is no-one around to hear?

Equally, a lot of the natural buyers for the UK market have disappeared.

Pension funds, for example, used to be significant holders of UK equities, but UK private sector pension fund holdings of UK equities fell from over 50% of the average pension fund portfolio in 2001 to just 4% in 2022^^^.

Alex Wright says the majority of this selling happened a while ago and no longer exerts a significant pressure on the UK market. His view is that it will be UK investors that will drive the market forward from here. They could well be drawn back by a combination of stronger economic performance and low valuations.

The bounce, when it comes, could happen quickly and catch investors unawares. The market has a lot of catching up to do. Smaller companies funds, such as Unicorn UK Smaller Companies and IFSL Marlborough UK Micro Cap Growth, are examples of funds which appear to be more geared to a recovery.

A more blended fund, such as Rathbone UK Opportunities, which has its largest weight in the FTSE 250 at 44%^^^^, but retains some large cap exposure, may give a smoother ride, while Fidelity Special Values will be more opportunistic and flexible. This could be the start of the fightback for UK equities.

*Source: Reuters, 10 November 2023

**Source: BBC, 15 November 2023

***Source: Merchants Trust, November 2023

****Source: MSCI index factsheet, 31 October 2023

*****Source: Unicorn Q3 2023 update

^Source: Investment Association, September 2023

^^Source: comparable data, as at September 2023

^^^Source: ICAEW Insights, 26 June 2023

^^^^Source: fund factsheet, 30 September 2023