Investors have grown used to the dispiriting performance of the UK market. Its focus on ‘old economy’ sectors such as energy and financials, the Brexit problem and a poor early response to the pandemic have left it languishing behind its global peers. However, since the start of 2022, it has staged a notable comeback. Could this be the start of a new era for UK markets?
The MSCI World index is down 4.2% over the past three months, dragged lower by the dominant US market with its high weighting in technology. In contrast, the UK market, in local currency terms, is up 7.1% over the same period. While no-one would suggest that three month performance should act as a guide, it is a notable change in fortunes for the unloved UK.
It is tempting to attribute this to a straightforward rotation from growth to value. The UK market is stuffed with ‘value’ type sectors and has therefore benefited disproportionately from the shift from a low interest rate, low inflation environment, to a rising interest rate, high inflation environment.
Undoubtedly, this plays a role. Banks tend to do well in a climate of rising interest rates because it allows them to improve their margins. Energy companies do well at a time of economic recovery because there is more demand. They have also benefited from rising energy prices in response to the geopolitical tensions in the Ukraine. Both these sectors are over-represented in the UK market. Equally, the UK market’s lack of large technology companies has undoubtedly helped its recent stability.
Low price does not mean low quality
But it is not the whole picture. Simon Gergel, manager of the Merchants Trust, points out that the UK market is still lowly rated. Looking at cyclically-adjusted P/E ratios, the UK is cheaper than almost all developed markets, including the US, Japan, France, Canada and Germany. It is also cheaper than a range of emerging market countries, including Mexico, South Africa, India and China. Gergel’s view is that the UK is cheap even when adjusted for its sector composition.
That said, he also says valuations are polarised: “Some of the growth companies in the UK have attracted a premium. It is certainly not as if every company is on a discount.” There are cheap companies and expensive companies and not a lot in between. However, he adds that investors should not assume that a low price means low quality. There are plenty of structurally sound companies on relatively low valuations in the UK market.
Gergel says: “It has been easy for international investors to ignore the UK market, but once it starts to move, that is more difficult and it is likely to get more interest. Not owning the UK market becomes a problem.”
The other area that may be positive for the UK market is on M&A activity. Private equity investors continue to snap up UK companies, viewing them as cheap relative to their global equivalents. There has also been activist shareholder interest from large global hedge funds in some of the UK’s major companies, including Vodafone and SSE. Gergel says this is usually a confluence of “low valuations and a real opportunity to change things”.
Drawing down on the Covid piggy bank
There are risks to this benign picture, however, mostly around the economy. The pandemic may revive, the prospect of war may bring risks to consumer and business confidence, at the same time as the cost of living is rising. Tax and interest rates could rise too high and may hold back spending. The UK political landscape is unstable.
Steven Bell, chief economist at BMO GAM, recognises the risks, but adds, “the doom and gloom in the UK is overdone”.
“We have our own Covid piggy bank in the UK, even if it is not as big as that in the US. Many people will suffer as energy prices soar, but I expect continued growth as people keep drawing down on this piggy bank.”
He adds that rises in the minimum wage are a sign that the UK consumer may be better supported than many people believe.
He points to recent PMI data that shows growing confidence across manufacturing and services. The most recent IHS Markit report said: “February data indicated a swift rebound in UK economic conditions after disruptions due to the Omicron variant at the turn of the year. Private sector output expanded at the fastest pace for eight months, led by a strong recovery in consumer spending on travel, leisure and entertainment.” Bell adds that recent data from the housing market also remains strong.
He believes that the public finances may prove most robust than many expect, clearing the way for potential tax cuts in the budget. This would certainly be a vote-grabbing strategy ahead of a likely difficult election for the incumbent government.
The UK market has had false-starts before and it has been cheap for a long time. While there are no guarantees that the UK won’t revert to its normal pattern of the last few years, it feels like there is more to its current strength than a simple value rotation. It also has many years of underperformance to make up and remains cheap.
If international asset allocators start taking a closer look, it could be the start of something interesting for UK markets.
