The UK is cheap compared with its own history and record cheap compared with the US, says Alexandra Jackson, fund manager, Rathbone UK Opportunities Fund. Which could boost small and mid caps if the economy starts to pick up in 2024.
More people will vote this year than in any other year in recorded history. In fact, half of global GDP is expected to go to the polls. Election cycles can be bumpy, but they can also bring economic stimulus to entice a weary electorate, either through extra government spending or lower interest rates. We expect 2024 to offer all this and more.
For our asset class, UK small and mid-caps, the path of interest rates will be watched closely. The performance of the FTSE 250 index has become very closely correlated to the five-year swap rate (essentially today’s forecast for interest rates over the next five years). As that rate rose precipitously in 2022 and 2023, mid-caps got bulldozed. It’s no great stretch to imagine that, as the forward curve rolls over, mid-caps could benefit. We’ve already started to see this happen in November.
But what about the poor economic outlook, you ask? It’s not as bad as many would have you believe. Even the Office for National Statistics had to drastically revise up its GDP numbers at the end of the summer. The UK is no longer an outlier in its post-COVID bounce-back. Consumers are in reasonable shape, with significant savings and low levels of debt. The rising interest burden from higher mortgage rates will drag, but will mainly be borne by the richest half of the country, who have even more savings than most. The labour market is so far resilient. Real wages are rising again, consumer confidence is slowly improving and even the forward-looking PMI data picked up a bit in November. The ball is very much in the Bank of England’s court; falling inflation should give them the breathing room they need to start cutting rates in the second quarter. We’ll be watching the labour market closely for signs of sticky inflation driven by wage pressures. If inflation continues to fade, increasing real wages plus easier financial conditions and excess savings can underpin better confidence and demand.
It will be a balancing act though; central banks are treading a fine line between taming inflation and growing recession risks in the short term, while investors must maintain a longer-term view. To help us assess what’s happening, we go back to our companies.
Cranswick, producer of sausages, crispy breaded chicken, humous and pet food recently commented that “market conditions in the UK are better, with a combination of improving volumes and easing inflationary pressure”. Property investor Sirius Real Estate talks about markets “unlocking” and has raised capital to take advantage of pricing opportunities. Even the beleaguered venture capital world is stirring once again. Quality retailers are beating expectations even in a cost-of-living crisis. All this is music to many ears.
Of course, not all companies will turn the corner smoothly. Those with high levels of floating-rate debt will see their earnings come under enormous pressure. And those who depend mostly on the vagaries of the economic cycle, with little internal innovation to drive growth, may well struggle as GDP growth across the developed world continues to shrink.
In such an environment, valuation is key to identifying the opportunities ahead. The UK is cheap compared with its own history and record cheap compared with the US. The discount is even more marked in small and mid-caps, where it’s near all-time highs, even including recessions. Never in this century have so many FTSE 250 companies traded on a price/earnings (P/E) multiple of below 10x. Investment bank JPMorgan recently reminded us that “the outperformance of [small and mid-caps] versus large is never greater than in the first year after a recession-linked equity market low”. And while the economic outlook may not be spectacular, on a 10.4x forward P/E ratio (FTSE All Share as at November 2023), we certainly don’t need spectacular growth to drive valuations higher. The bar is set very low for a positive surprise.
Going into 2024, we like names with low leverage, innovation that drives market share and evidence of secular growth (meaning revenues aren’t wholly dependent on the business cycle). We’re also looking for companies that generate lots of free cash flow, which can be used to fund more organic innovation, buy back shares or pay for accretive M&A deals. There’s no shortage of these kinds of opportunities on the London market, it’s just the appetite that’s been missing.
Quality, liquidity and active management remain our focus.
