After a long-time in the investment wilderness, the UK appears to be back in favour. UK equities have raced ahead of their peers over the past six months. What has turned the tide for the UK? And can it last once the relief over a Brexit deal and economic recovery has subsided?
The biggest factor in the UK’s turnaround has been sentiment. In theory, with only around a quarter of its revenues coming from the domestic economy, the UK market should have been only lightly affected by the uncertainty on Brexit and the poor pandemic response. Instead, the UK has been sent to investment purgatory by investors for the past four years.
‘Markets aren’t as efficient as we’re led to believe’
Aberdeen Standard head of UK equities Andrew Millington says that the UK economy has mattered a lot more to the UK stock market than it should have done.
“When we look at valuation, since 2016, UK stocks have traded at a discount to elsewhere, even when you adjust for the sectors they operate in and even when those sectors are truly global,” he says. “Markets aren’t as efficient as we’re led to believe. International investors have been looking at what’s happening and decided to allocate elsewhere.”
As such, the more encouraging recent figures from the UK economy, plus some clarity over the Brexit deal have been helpful in drawing investors back to the UK economy.
It seems that the rest of the world has spotted a bargain, realising they can get access to global trends at knock-down prices.
Fidelity Special Values trust manager Alex Wright (pictured) says: “A lot of the trends we’ve seen with the Covid recession… have been global trends and started in other areas first… Even though you’ve seen them in other markets, you’ve been able to buy them in the UK market before they’ve been fully priced in.”
This extends into demand from other corporates and private equity. There were plenty of takeover bids over the last year: including William Hill and Apollo, plus McCarthy and Stone and Lone Star. With valuations in the UK market low valuations and a lot of private equity money available, it has made sense for overseas corporates to buy UK plc on the cheap.
UK has had further to recover than most
A final reason may be because the UK simply has more recovering to do. Brexit ensured that it didn’t fully participate in the recovery from the global financial crisis from 2016 onwards. Investment stalled and growth weakened. Equally, it was hit particularly hard by the pandemic because more of its GDP was focused on areas such as restaurants, hotels, holidays, which were damaged by lockdowns. In contrast to, say, China where the economy is back up and running, the UK has a long way to bounce back and therefore stronger growth ahead.
UK smaller companies have been the first beneficiaries of the resurgence. Over the past 12 months, it was the second best performing Investment Association sector (after North American Smaller Companies) with the average active fund up 70.7%. In the past six months, even unloved UK equity income has started to pick up: it’s the third best performing sector, up 23.3%.
From here, the key message from fund managers is not to neglect long-term growth in favour of cyclical recovery. Companies that are reliant solely on a precarious recovery could struggle make further progress. For example, Wright points out that some of the obvious beneficiaries of reopening have already recovered a long way.
“The prices for these reopening plays are suggesting that things will get back to where they were in 2019 and sometimes even better,” he says. “While in some sectors, the amount of capacity being withdrawn will mean that is the case, I need to be convinced that things are going to be better than before.”
Watch out for value traps
Investors need to distinguish between value opportunities, and companies that are cheap because they are structurally challenged. There are many UK companies that may fit into this box: the oil sector, for example, has a difficult transition ahead, and areas such as tobacco are likely to rub up against ESG considerations.
There are plenty of companies that offer both long-term growth and compelling valuations, says Wright. “On the ground, things are almost universally better than expected, better than pre-Covid in many cases,” he says. “Company demand has held up, efficiency has increased. There are companies coming out with better-than-expected results, even though valuations are still very low.” He likes the insurance sector, for example.
This would also argue for continued progress in smaller companies. Standard Life Smaller Companies trust manager Harry Nimmo says: “Our high quality stocks have traded off quite significantly since November. Comparing the valuation of our portfolios with where they were a year ago, they’re looking cheap… It seems to us this is still a pretty good buying opportunity.”
Certainly, many of the investment trusts remain on a significant discount to net asset value, suggesting that there is no obvious exuberance in the market.
There are some caveats: the Deliveroo floatation showed that UK markets still don’t tend to give companies the benefit of the doubt where there are doubts on their longer-term growth prospects. Had the same float happened in the US, investors may have been willing to overlook some of the company’s weak spots, but this wasn’t likely to happen in the UK. Wright believes there has been a distrust of the UK market and that could take time to reverse.
Equally, the economic recovery is fragile. The difficulties around Brexit seem to be more than teething problems and a lot is premised on the ongoing success of the vaccine rollout. Nevertheless, for the time being at least, it appears we have entered a new era for the UK.
