By Henry Dixon and Jack Barrat, portfolio managers at Man Group
Despite having to contend once again with unforeseen and unwelcome events in 2023, the UK equity market delivered a welcome positive return.
Moreover, the much-anticipated recession – despite interest rates more than doubling and inflation far exceeding expectations – remained elusive.
If this has provided a pleasant surprise, the ongoing negative has been the unrelenting exodus of money from the UK equity market.
Compounding these outflows has been the move by some companies to seek other domiciles for the listing of their shares. The aggregates business CRH, for example, chose to relist in the US in search of a more favourable regulatory regime and ultimately a better valuation.
It has therefore once again been a period in which it has been easy to be pessimistic. However, we believe there are four key reasons to challenge this mindset.
Improving competitive dynamics
The financial performance and the capital allocation of many UK companies should be applauded. This improvement has much to do with higher nominal growth, but also higher interest rates have assisted the competitive landscape. To make this latter point we would observe that business creation has now turned negative.
While this might concern some, we would highlight the benefits to productivity of certain corporates no longer funding losses ad infinitum. The effect that this can have on industry dynamics should not be underestimated.
See also: Bank of England holds interest rates steady at 5.25%
Turning to capital allocation, the improved cash generation is driving growing dividend yields and an ever-rising level of buyback activity. Set against the low level of issuance, cash returns from the market are at decade highs.
Valuations and corporate activity
In our view, too much is made of delisting. Indeed, while there should be some reflection in losing a company such as CRH, the process of delisting has resulted in a notable uplift in valuation. When combined with attractive earnings growth, the shares have risen by over 60%, which provides a clear roadmap for some other companies.
The prevailing levels of valuation have not escaped the attention of trade buyers, even in what would have to be described as a difficult environment for raising debt. Thirty-nine companies in the UK with market capitalisations over £100m were the target of bid activity last year. The average premium offered was 58%.
Signs of a reversal
Despite a lacklustre earnings performance from the UK market in 2023, the absolute value case for UK equites remains. This is at a time when the relative argument versus other markets has rarely been stronger.
The journey to this relative discount has been lengthy and well documented, but we sense certain elements are starting to reverse. Qualitatively for example (in a year when so many democracies are going to the ballot box with highly charged alternatives on offer) the UK’s leading candidates represent variations of centrist politics. Also, more quantifiably we would observe that our inflation rate, which was concerningly diverged from G7 peers, has started to normalise.
Lower inflation provides a welcome domestic boost in two forms. Firstly, consumer spending should improve. In the last two years, wage growth, contrary to expectations, has offset a step change in utility bills and outsized food inflation. This year wage growth is set to persist, helped by a c10% rise in the national living wage in April. When combined with falling utility bills, a healthy increase in income available for discretionary spend should be expected.
See also: Is UK inflation is ‘finally coming to heel’? CPI data falls to 3.4% for February
In terms of the government, while UK debt to GDP is not an outlier versus other G7 economies, there is a far greater emphasis on index-linked debt.
The recent surge in inflation has therefore pressured the fiscal position on account of elevated debt servicing costs, and remedial actions such as a rise in corporation tax were actioned. However, with inflation starting to moderate faster than the OBR forecast, fiscal headroom is emerging.
Earnings
In similar fashion to last year, the aggregation of bottom-up forecasts expects no growth.
Inflation and interest rates have dominated the conversation in asset markets, but less attention has been paid to the cumulative rise in nominal GDP and the impact this is likely to have on long-run profitability at the corporate level.
Over the medium to long term, revenue, profit, and cashflow produced by companies in aggregate normalises to grow in line with nominal GDP. Since 2019 the US and UK have seen a greater than 25% and 30% increase in nominal GDP respectively, and it is thus our contention that the starting point for many company’s earnings is not the pre-Covid level so often referred to, but a number almost a third higher. That leads us to believe the outlook for corporate profitability is potentially much higher than a pessimistic consensus currently expects.
Admittedly all this seemingly good news has not escaped investors’ attention, and in stark contrast to last year, the recession narrative has abated. However, we see precious little evidence to suggest that this shift in mindset has made its way into positioning or consensus forecasts.
We have entered 2024 with a downbeat narrative, low starting valuations driven by record outflows, buoyant household cashflow, moderating inflation, a more stable political environment, with our corporates demonstrating good capital discipline, and where we believe high nominal inflation might lead the profit outcome to be materially better in places than a pessimistic consensus. The building blocks are there to build a portfolio that represents strong absolute valuation, balance sheet resilience and that can surprise positively in the year ahead.
See also: Will bumpy inflation figures defer the interest rate cuts markets hope for?
