The relative underperformance of the UK driven by weak growth, low productivity, spikey inflation, ham-fisted government policy and an index devoid of tech is well known. However, the scale and persistence of selling has brought valuations to levels that can’t be ignored. Trading on 11x forward P/E, the FTSE All Share is at a 20% discount versus its historical average of 14x since 1990. And versus the US, it is close to a record discount of 45%.
Last one out, switch the lights off
To the end of April 2024 there have been 35 consecutive months of outflows from UK equities. When you combine this with UK pension funds having reduced their UK weighting to 5-6% from highs of 40% in the 1980’s, it’s easy to see why the FTSE All Share has struggled to keep up. However, from here it feels reasonable to question, who’s left to sell? There are also signs that winds of change are beginning to stir. The FTSE 100 recently set new all-time highs and the outlook for investors is improving. And this is all feeding into better absolute and relative performance since January, as seen in the chart below.
Equity returns 31st January 2024 – 17th May 2024
Source: FE fundinfo2024
GDP growth, positive real incomes, and lower interest rates
There’s a growing list of positives emerging to support accelerated UK earnings growth and possible valuation re-ratings. We’ve come through a long period of high inflation, which has significantly squeezed household incomes. But we’re now on the cusp of converging towards the Bank of England target of 2%. This is likely to lead to a reduction in interest rates, helping to ease financing pressures for businesses, households, and the government. This in turn should, support economic activity and buoy domestic consumption and capital investment. Finally, as real incomes turn positive and consumers no longer feel the need to save more for contingency (saving rates are over 10% vs 7-8% historical average), we should see rejuvenated consumer confidence.
GfK consumer confidence
Source: GfK and FT
Lower mortgage rates are expected to breathe life back into the property market. This will help reinstate positive wealth effects for households and lift activity in the construction sector. All these factors are expected to raise GDP growth above expectations in 2024 and towards 2% in 2025. This would be faster than the US – something we’ve not seen for a long time!
Dividends, buybacks, M&A
In the same way that the UK economy is beginning to find its mojo, so too are the animal spirits amongst corporate management. Recognising the undervaluation of their company share prices, boards are increasing buybacks, raising dividends, and exploring ways to enhance and realise shareholder value. The rising volume of unsolicited bids for UK companies combined with the average premium of just over 50% to pre bid share price further testifies the ‘cheapness’ of UK plc, and investors are beginning to take note.
Source: Jupiter Asset Management
Cyclical and yet low beta
Arguably, one of the greatest long-term attractions of the UK market for multi asset investors is its index composition. Being skewed to cyclicals (e.g. financials, industrials, energy, materials) and consumer staples, the UK offers differentiated risk adjusted returns. This is hugely valuable in a diversified portfolio. There’ll be times when this can act as a drag for investors, as we have experienced for a few years recently. However, looking forward it feels like this headwind is beginning to change to a more favourable tailwind.
Interestingly, the UK also doesn’t tend to be sensitive to global growth trends. So, if the US slows from its current questionably unsustainable pace of expansion, the UK offers investors a relative opportunity – a bit like the tortoise and hare!
Cheap valuations are helpful but never sufficient in isolation
Valuation is known to be a useful guide to future returns over the long term. However, it’s rarely enough by itself to catalyse near term outperformance. However, we’re starting to see more talk of proposals by policy makers and political parties to enhance the competitiveness and attractiveness of the UK financial services sector.
Whilst the British ISA is unlikely to shift the needle, it’s well intentioned. What would be more meaningful would be:
- reduce, or better still remove, stamp duty on UK equity purchases
- raise the minimum contributions to auto enrolment
- increasing tax deductions on UK dividends
- require minimum levels of UK equity exposure within UK pensions
The latter may be controversial. But at the moment we’re giving tax benefits to pension schemes who allocate capital overseas, enhancing their competitiveness at our expense. This makes no sense. Encouraging greater domestic investment supports improved productivity growth, job creation, GDP, tax revenue etc, helping to move us onto a more sustainable economic footing.
Encouragingly, it appears much of this is being lobbied for inclusion within the main political party manifestos – fingers crossed talk is turned into action.
Sunny with showers
Within our strategic asset allocation, the UK remains a core building block because of its proven differentiated risk adjusted returns. The diversification benefits have been absent for a while. However, we believe over the long term, foregoing some short-term return for greater consistency of risk adjusted returns will be an appropriate and rewarding strategy for investors.
As things incrementally improve, the unloved, under-owned and undervalued status of the UK looks set to change for the better – hopefully representing a brighter outlook for investors.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.