Investors must be patient with UK equities, argues Fund Calibre’s Darius McDermott
A successful vaccine roll-out and the conclusion of a Brexit trade deal saw optimism for the UK economy burst into life earlier this year, prompting many experts to point to an opportunity for UK equities to pull back some of the 40 per cent discount they were trading at versus their global peers.
As recently as July, the International Monetary Fund was projecting the UK economy would grow by 7 per cent in 2021 – the largest of any developed economy alongside the US*. Fast forward a few months, and optimism has given way to concerns once again. According to ONS data, UK GDP rose 0.1 per cent month-on-month in July 2021, a significant contraction on the 1 per cent growth in June and significantly below the 0.5 per cent expected**.
Although the UK’s economic momentum has remained positive following the relaxation of most of the pandemic’s restrictions, Lazard Asset Management says staff shortages have weighed on the UK’s recovery, compounded by supply chain disruptions and self-isolation requirements that had been in place for contacts of people who had tested positive for Covid-19. All of which has resulted in the hopes for UK growth estimates returning to pre-pandemic levels being pushed back to mid-to-late 2022***.
One area which has picked up is M&A activity, with UK companies in demand from private equity firms. In the first half of 2021 we’ve seen almost £30bn worth of private equity deals take place – to put that into context we’ve not seen more than £15bn in a year since 2007****.
Schroder Income Growth manager Sue Noffke says UK-listed companies are being picked off by overseas private equity buyers and overseas industry peers, all of whom are taking advantage of the valuation discounts which are often “completely unwarranted”****.
I think investors have to be patient with UK equities a little longer – but one thing I feel they must do is split UK investing into two distinct categories, one of which looks far more attractive than the other. The golden rule is not to let the unattractive sector shroud sentiment for UK equities on the whole.
I’ll start with the unattractive option. There is no getting away from the fact the FTSE 100 is full of boring, old economy stocks. A major reason why the index has gone nowhere for two decades is because half of the value of the FTSE 100 is represented by commodities, financials and consumer staples. Before anyone shouts at me, I am fully aware this was the case two decades ago, however 30 per cent of the index was also in technology, telecoms and media stocks – this is significantly smaller today^.
There is a strong argument that the only trigger for an upturn for the blue-chip index would be a prolonged value rally. We’ve always pointed towards inflation as a catalyst for this – and the ongoing supply and demand concerns do indicate that inflation may be more endemic than many initially thought. The likes of energy and financial companies are a good hedge against inflation.
But it’s a big call to back inflation at a time when the Bank of England is fighting against it, I can see rates going to 1.5 per cent in the mid-term but the economy can’t stand much more than that.
Which brings me to UK mid and small-caps, an area where there are plenty of opportunities. While the FTSE 100 has been stagnant in the past 20 years, the FTSE 250 has, by contrast, risen 3.5 fold. Figures from Fidelity also show that while the FTSE 250 looks more expensive than the FTSE 100 – with a price that’s 17.7 times expected earnings versus 12.5 for the blue-chip index – the outlook justifies those numbers and more. Forecast figures from Goldman Sachs estimate FTSE 250 earnings will grow five times faster than those in the FTSE 100 (53 per cent vs. 9 per cent)^.
Then there are UK small-caps, the most resilient of sectors in the past five years. If we are entering a stockpickers market, these are likely to be the prime hunting grounds for future upside returns.
We’ve always felt small and mid-caps are the best way to generate long-term returns, but that case looks even stronger in the UK. We just have to be patient as M&A activity, coupled with the addressing of supply side issues, starts to turn sentiment around as investors realise the opportunities within certain segments of the UK market are attractive.
Investors may want to consider options like the LF Gresham House UK Multi-Cap Income fund or the Schroder Income Growth trust, as a way to tap into a diverse range of UK companies, whilst preserving the income element. While those specifically targeting mid or small-cap UK equities may prefer the Axa Framlington UK Mid Cap or the TB Amati UK Smaller Companies fund respectively.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
*Source: IMF World Economic Outlook – July 2021
**Source: Yahoo Finance article – dated 10 September 2021
***Source: Lazard UK Equities Outlook – October 2021
****Source: Schroders – Q&A: why are so many investors still ignoring the UK stock market?
^Source: Fidelity – Stockmarkets around the world – at 30 September 2021
This article was first published in the November 2021 issue of Professional Paraplanner.
