Is now the time to be buying UK equities? Darius McDermott, managing director, FundCalibre, looks at the pros and cons of backing Britain and talks to fund managers on their views of the UK economy and the impact on the markets.
It seems whichever sector or region I talk about at the moment, the phrase “it’s darkest before dawn” comes to mind.
But perhaps the statement is most applicable for UK equities. The International Monetary Fund recently announced that the UK economy will shrink (by 0.6 per cent) and perform worse than all other advanced economies – and even Russia – in 2023, as the cost of living continues to hit hard. It’s a stark change from the start of 2022, when economists predicted a steady recovery following the pandemic – war and inflation change all of this.
The anomaly is the UK stock market was arguably the most resilient of indexes in 2022, with the FTSE All-Share Index delivering total returns of 0.34 per cent*. This was principally down to the high concentration in companies that benefit from higher commodity prices in the FTSE 100 through their overseas exposure. To put this in context, the top 20 companies in the FTSE 100 returned almost 16 per cent last year, with the other 80 down 17.2 per cent*.
However, UK small and mid-caps, were both down 17 per cent respectively* – as their increased domestic exposure hurt. What we can say for certain is that the UK now looks cheap on every single metric.**
Reasons to invest in UK companies
I’m sure many of you are saying we’ve heard this all before! You have, but there are a few reasons to consider that make me think now could be a sensible time to look at UK PLC.
The first is that there is more chance we are facing a more modest recession. As Janus Henderson portfolio manager Laura Poll points out, not only have consumers saved courtesy of the pandemic – helping manage the cost of living pressures – but the labour market is also entering the recession from a position of ‘tightness’, and ultimately the key factor in consumer spending power is whether someone retains their job*.
UK listed balance sheets also remain healthy, while bank lending has learnt the lessons of the GFC, with strict affordability tests – meaning many lenders are not under pressure as interest rates rise*.
The latest rate rise brings me to timing – which is fundamentally important. I’d like to take a trip back to 2006 as an example: the market was super-optimistic back then, yet rates peaked at 5.25 per cent. We are currently in the face of a huge cost of living crisis – a huge economic concern – so the argument is how can rates reach those levels in the UK based on these concerns? It looks like inflation is starting to be managed – and the hope/growing expectation is that interest rates will start to fall back – the 6 per cent figure anticipated post the Autumn Budget now seems less likely.
Opportunities further down the market-cap
Schroder Income Growth manager Sue Noffke says she and her colleagues are finding numerous opportunities in the SMID market. She says: “We see opportunities in the ‘domestics’ serving the UK consumer and the business end users, and the many internationally focused SMIDs**.”
“Valuations are very beaten up and the market does not seem to be discerning between good and less good companies,” she adds**.
Laura Foll says UK smaller company valuations are already trading at levels rarely seen outside of severe recessions. She says: “That does not mean there is not further potential downside to share prices, or that there will not be economic shocks to come. However, it does suggest to us that a significant degree of economic ‘pain’ is already reflected in UK share prices.”
What if things continue as they are?
Jupiter UK Alpha manager Richard Buxton says although there are reasons to be more constructive, his concern is that while inflation is coming down, if the wage element is stickier and the oil price isn’t helping anymore, there’s a chance that interest rates will have to stay where they are as inflation targets could still feel a long way off.
He says: “Consequently, I think we’re likely to get a second phase to the bear market. We’ve not yet had that capitulation where people panic and want to exit quickly, but I think we could see that either later this year or in 2024.”
I’d argue a large element of the concern around UK equities is already priced in. I’d expect the market to remain sluggish for a tiny bit longer, but we are seeing positive news flow. If investors can face the headwinds I think there is significant value to be made from here.
Funds to consider
The multi-cap approach – JOHCM UK Dynamic
Alex Savvides’ process is all about ‘corporate change’ and he scours the market for undervalued companies that are making positive improvements to their businesses.
The forgotten mid-caps – abrdn UK Mid-Cap Equity
This is a high conviction strategy backed by a leading mid and small-cap team and their powerful quantitative tool ‘The Matrix’. It targets businesses when they are well established, but still have a long runway of growth potential.
Rebounding small-caps – TB Amati UK Smaller Companies
This fund is managed by a highly experienced quintet of small cap specialists. The portfolio of 65-70 companies focuses on structural growth businesses, which the managers believe can add value in the under-researched small and mid-cap part of the market.
Pros to investing in the UK
– Cheap – particularly small and mid-caps – and unloved
– Very low allocations from global fund managers – potential for buyers to enter
– Large deep smaller companies segment
– There is dollar exposure if you want it
Cons to investing in the UK
– Remains unloved post Brexit, with large outflows
– Limited exposure to certain growth sectors (technology) and overweight narrow sectors (energy/financials)
– Income heavily driven from small number of companies
Sources
*Source: Janus Henderson – UK equities – reasons for optimism in 2023
**Source: Schroders – Outlook 2023, UK equities: mispriced opportunities abound
***Source: Jupiter – Notes from the Investment Floor: Sluggish UK Growth, but reasons for cautious optimism
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.
[Main image: paul-fiedler-MKaQ4KOEssk-unsplash]
