With the Bank of England base rate having reached a 15-year high of 5% last week, savers with cash deposits have been rewarded with a higher (although still below-inflation) return on their assets.
However, while cash may once again be king for a certain demographic, largely likely to be those who own their homes outright, for UK equity investors it is also a vital catalyst that could put an end to years of relative underperformance versus other markets.
Iain Pyle, manager of Shires Income Trust, an Abrdn-managed closed-ended UK equity income fund, says that the current higher interest rate and higher inflation environment could make it a good time for both foreign and domestic investors to re-engage with the UK equity market.
Looking at periods of history prior to the global financial crisis (which ushered in a period of artificially low interest rates that many may now regard as ‘normal’), he argues that we may be at an inflection point where interest rates need to remain higher for longer in order to combat persistent inflation. “In that scenario, the US is less likely to continue to outperform,” he says.
In a period when interest rates are not super-low and inflation is more of an issue, the ability of growth stocks to rise – which have been a driving force in the outperformance of US equities – is much less, and that removes a headwind for the UK, which has suffered a marked decline in valuations since the Brexit referendum in 2016..
“The relative cheapness of the UK is not new news, but it is still surprising – the US is trading near the top of its historical valuation range whereas the UK is by some distance the cheapest region,” the manager says. “With GDP forecasts picking up, closing the gap versus the US and EU, there are fewer reasons to be bearish, and we believe the UK represents a real value opportunity.”
As an income investor, Pyle points to data showing that dividends have made up around 70% of long-term equity market returns, and says that in an environment where share prices may be subdued, this proportion is likely to go up even more. “The UK market dividend yield is almost double that of the US, companies are relatively unindebted, and their ability to protect and grow their dividends is pretty good despite some bearishness on the economy,” he adds.
Low corporate debt – or particularly companies with cash on their balance sheet – are also seen as a significant area of opportunity by Gervais Williams, manager of the Miton UK MicroCap Trust and The Diverse Income Trust.
While foreign investors – either trade or private equity buyers – have been taking advantage of low valuations in the UK mid- and larger-cap space to snap up strategic assets, Williams points to the potential for cash-rich small and micro-cap companies to absorb distressed competitors as tighter financial conditions lead to a greater level of insolvencies.
“Some companies are beginning to go bust and we would expect to see more corporate failures in the next 12 to 18 months,” he says. “That will give the stronger companies that remain the opportunity to expand into the market gaps that are left, and will increase the pool of available staff. Also, the smallness of smaller companies allows them to grow even in less favourable conditions, by sucking up ‘zombie’ companies.”
Williams argues that when small companies fail, many private businesses might struggle to raise the necessary finance to buy them up, while for larger acquirers – for example, Next, which bought Made.com out of receivership for £3m – the impact of such acquisitions is unlikely to be as great as it would for a smaller listed buyer. Made.com had a market cap of £775m (c $1bn) at its IPO in mid-2021, but by the end of 2022 it had gone bust.
Williams says the total consideration paid by Next (including working capital) was perhaps around £30m, and a realistic valuation for the former company might be £300m. “It was a good deal for Next, but as an £8.5bn company, it would not have as much impact as it would for an £850m company, and for an £85m company it would be completely transformative.”
Meanwhile, money continues to leak out of open-ended UK equity funds – net retail outflows of £1.1bn in April marked a 24th consecutive month of declines, according to the Investment Association, with short-term money market funds (i.e. effectively cash) being the top-selling sector, with £770m of net inflows. If Pyle and Williams are correct, these ‘cash is king’ investors may be missing a trick when cash on the balance sheet is shown to be the real winner.
