- Recession puts Jeremy Hunt and Rishi Sunak on a sticky wicket ahead of the Budget
- What investors should make of recession in the UK
- UK stock market performance has lagged global peers for ten years
- Is the UK undervalued?
- Why invest in the UK?
- Four funds for investors to consider
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“The UK fell into recession at the back end of last year and projected growth for 2024 is feeble enough that there may be further contraction to come. The recession pours ice cold water on Rishi Sunak’s pledge to grow the economy, and puts Jeremy Hunt on a sticky wicket when it comes to the forthcoming Budget. Weak economic growth means there may not be enough money to fund crowd-pleasing tax cuts, so the chancellor may resort to robbing Peter to pay Paul. Indeed, rumours doing the press rounds today suggest the Treasury is considering spending cuts to fund its giveaways.
“For investors, it’s important to bear in mind the UK economy and stock market are tethered, but not identical. The UK stock market has a lot of international operations, with around 75% of FTSE 100 revenues coming from overseas, falling to around 60% for the FTSE 250. Of course, that still leaves a substantial minority of revenues dependent on UK economic activity, and in a globalised market it’s very easy for UK investors to skip over to the US with their money. Indeed, many domestic UK fund investors have been doing just that, as outlined here. Across the pond the stock market derives the lion’s share of its revenues from the American economy, which is performing quite nicely, and only has a few percentage points of exposure to the UK.
Recession is water off a duck’s back for UK investors
“The stock market is a forward-looking weighing machine, and so a 2023 recession doesn’t materially change the prospects for companies in the future. It’s notable that the FTSE 100 reaction following the news of the economic contraction was in fact positive, which tells us that recession is water off a duck’s back for UK investors. Actually the market is probably more focused right now on when the first interest rate cut will come, and a recession makes that more likely to be sooner rather than later.
“The UK stock market has been a laggard on the global stage for most of the decade. A brief flurry of excitement in 2022, prompted by surging energy shares at the same time as a tech sell off, ran out of steam pretty quickly. The only previous time the UK has outperformed the MSCI World Index in the last ten years is during 2016, when the Brexit vote prompted a fall in the pound, helping to bolster the share prices of international-facing companies of the UK stock market. Over the last decade the FTSE All Share has returned 5.2% a year, compared with 10.1% from the MSCI World Index, in local currency. Things look a little worse for UK investors, as in pounds and pence the MSCI World has returned 12.2% per annum, thanks to sterling weakness (data from FE to 14 February 2024).
Source: FE total return in local currency
“The MSCI World Index is heavily dominated by the US stock market, so there’s a case to be made that the underperformance of the UK is perhaps a case of American exceptionalism rather than British failure. There’s certainly a large portion of truth in that, but over the last decade the UK stock market has also been outshone by European and Japanese counterparts. The MSCI Europe Ex UK index has returned 6.8% per annum and the Topix index of Japanese shares has returned 10.1% per annum, in local currency terms, compared to the UK’s 5.2% annualised return. The S&P 500 tops the major developed market leaderboard with a return of 12% per annum over the last ten years (total return data from FE in local currency to 14 February 2024).”
Is the UK undervalued?
“Bad performance doesn’t necessarily equate to a buying opportunity, but there are few who would dispute that UK valuations are at a low ebb, especially in relation to the US. There are many ways to look at valuations, but the Cyclically Adjusted Price Earnings Ratio (CAPE) is a widely used measure amongst economists and investors. This measure is like a standard PE ratio, except rather than only looking at one year of earnings, it looks at the last ten, to provide a picture across the business cycle. As at the end of December, the UK was trading on a CAPE ratio of 15.6, compared to 32.0 for the US stock market, according to data compiled by Barclays in conjunction with Yale’s Robert Shiller. On this measure then, the US is twice as expensive as the UK stock market, a 50% discount which will have the antenna of value investors twitching like crazy. However the picture is more nuanced than these figures first suggest.
Source: Barclays to December 2023
“If we look at the CAPE ratio over time (chart above), we can see that for most of the last 40 years the US stock market has traded at a premium to the UK. This makes some sense given these markets have different sectoral compositions, investor bases and levels of liquidity. Rather than comparing the CAPE valuation of the markets directly therefore, it’s probably a better idea to compare each with its own history. The UK currently trades at an 11% discount to its long run average CAPE, compared to a 31% premium from the US stock market. So compared to its long run average, the UK is undervalued, but the picture is not as stark as if you compare the valuation directly with that of the US stock market.
“What’s more, comparing the UK to the US is using an expensive yardstick to judge value. As the chart below shows, other European peers are trading at much more modest valuations than the US when compared to their own history, especially Germany. Again, this suggests looking at purely headline valuations measures, such as the current CAPE, can lead to lowballing the UK’s relative position. That said, in and of itself the market is trading at a discount to its long run average, which makes it of interest to value investors. In order to realise that value though, the market at large needs to come around to the same way of thinking, and the exodus from UK equity funds indicates UK retail investors are still pointing in the opposite direction. It’s a bit of a chicken and egg situation to determine what needs to come first, better fund flows into the UK or improved stock market performance. But if we see flows start heading back into UK equity funds, that could be a signal the tide is turning.”
Source: Barclays to December 2023
*Data from 1981 for all markets apart from France, which starts in 1999
Why invest in the UK?
“The relatively low valuation of UK companies might deter companies from listing on the London Stock Exchange, but it provides some reassurance for those considering putting their money into the Footsie. Investors shouldn’t bank on an immediate catalyst for a re-rating of UK stocks which would see the market move back towards its long-term average. Especially while investor sentiment remains weak and a UK general election later this year provides a source of worry for those who are looking for one. But as well as providing the possibility of an upgrade at some point in the future, low valuations also provide some downside protection because a lot of bad news is already in the price. That benefit is easily overlooked.
“That’s perhaps especially the case with the UK stock market because it can trade sideways and still deliver reasonable returns through dividend payments. Dividends are a speciality of the UK stock market and provide a considerable dollop of jam today for those patiently waiting for a turnaround. The FTSE 100 is forecast to yield over 4% this year, according to the AJ Bell Dividend Dashboard, and dividends can be expected to rise over time, though not necessarily without setbacks along the way.
“More adventurous investors might also consider investing in the small cap segment of the UK stock market, probably through a fund or investment trust run by a professional manager. This is a market which has historically been a source of high returns, albeit with greater risk. The UK small cap market is currently laid low, and things may get worse before they get better, but a turnaround in investor sentiment towards the UK could see this part of the market rally harder than the big blue chips.”
Funds for investors to consider
Liontrust UK Growth – Anthony Cross and Julian Fosh have run this fund since 2009 and look for companies with a strong competitive advantage and robust balance sheets. The fund benefits from a management team with a clear philosophy and process that have been tried and tested over time. The longevity of the team and consistency of implementation provides credibility, with a strong focus on long-term sustainability of profitability of the companies held within the portfolio.
City of London Investment Trust – Job Curtis has been running City of London since 1991 and the trust has raised its dividend every year since 1966. The trust mainly focuses on big blue chips that are reasonably priced and have sound finances. The trust currently offers a yield of 5.2%. This is variable and not guaranteed, though the company didn’t cut the dividend throughout the financial crisis or during the pandemic.
iShares UK Equity Index – at an annual charge of just 0.05% per annum, this fund provides cheap and cheerful access to the broad UK stock market.
WS Amati UK Smaller Companies – Dr Paul Jourdan has been running this fund for over twenty years and the whole team is steeped in experience when it comes to small cap investing. They look for high quality companies with competitive advantages. They have an emphasis on the AIM market, but they can invest in stocks all the way up to the FTSE 250. The smaller companies focus makes this worthy of consideration for more adventurous investors.
