Once again it looks like the year is going to finish with the UK stock market being a notable laggard on the global stage. So far this year the FTSE All Share has returned around 4%, compared to 14% from the S&P 500, and over 10% from the European stock market.

The UK has been viewed by some as unloved and undervalued for a while now, and with a reasonable amount of justification. But there are longstanding trends which go some way to explaining the negative sentiment towards the UK market, and which don’t look like shifting in the immediate future.

UK IN GENERAL IS UNLOVED

One current malaise affecting the UK stock market is negative sentiment towards the UK economy. The IMF predicts the UK will grow by only 0.5% this year, and by 0.6% next year. The UK economy and the UK stock market are of course two very different beasts. Around 80% of FTSE 100 revenues come from overseas, and that falls to around 60% for the FTSE 250.

However, you can turn those figures on their head, and say that still means 20% or 40% of the respective revenues of these indices come from the UK. If you have a negative view of the UK economy, why would you want such a big slug of exposure? Especially when you can hop across the pond and invest in the S&P 500, which has only a few percentage points of its revenues derived from the UK and has been performing very nicely.

There is widespread acceptance that interest rates look to have peaked in the UK, and markets are actually now anticipating three rate cuts in the second half of next year. On the face of it that should be good news for UK economic growth, but that’s not the whole picture. The Bank of England reckons that only half of the interest rate hikes pushed through in the last two years have taken effect on the economy.

Analysis from the IFS and Citi back this up. Their figures show the spike in housing costs from higher mortgages and rents will actually peak in the first quarter of 2025. That’s not because interest rates are forecast to rise, but because mortgage holders across the country are only gradually rolling off older and cheaper fixed term deals.

NOT OUT OF THE WOODS YET

Inflation receding and interest rates flatlining or even falling in future is undoubtedly good news for the UK economy, compared to the alternative. But it feels premature to say we’re out of the woods just yet. And the very sizeable and rapid shift in monetary conditions we have witnessed presents large downside risks to economic forecasts. Ultra-low interest rates and QE were an experiment that took us all through the looking glass, and we have now been unceremoniously yanked back into the real world where borrowing money actually costs us a pretty penny. A period of adjustment is only to be expected. Add in the fact that the tax burden is forecast to rise to a post war high in the next five years, and you can see how UK consumer purses might not be precisely gushing for some time to come.

The good news about the economy at such junctures is that it is cyclical. Better rates of growth will return to these shores at some point. And while the US economy is performing well, many of our European cousins are not doing so much better than us. The German economy, in particular, is forecast by the IMF to contract by 0.5% this year.

THE IMPACT OF PASSIVE INVESTING

Perhaps not as transitory is the appeal of passive investing, a trend which has been gathering pace for the last decade, and which might be partly responsible for the UK’s lacklustre performance. It’s true there are plenty of passive funds available which track the UK market, but logically, passive investing is a global game. If you simply want to follow the stock market based on the size of the companies in it, then it doesn’t make a huge amount of sense to limit yourself to just the UK. Doing so is actually making an active decision about regional asset allocation. Granted some people will take this approach, but many more passive investors, and indeed professional active investors who are tied to a benchmark, will invest globally. Currently that means investing around two thirds of your portfolio in the US, and only around 4% in the UK. A global stock market tracker now has greater exposure to each of Apple (AAPL:NASDAQ) and Microsoft (MSFT:NASDAQ) than it does the whole of the UK stock market. There is a legitimate question about whether the strong showing of the US stock market and weak performance of the UK stock market have now gathered a momentum of their own because of the rise of index investing, which favours the big at the expense of the small.

WHAT THE UK IS GOOD AT

There are some things the UK stock market is undoubtedly good at, and one of those has to be providing dividends. That makes it an attractive destination for income seekers. The UK’s small cap sector is also worthy of a mention. Like the rest of the market, it’s laid low at the moment, but has delivered dazzling returns over the long term.

Looking at the UK market as a whole, it does look undervalued, both compared to the US and its own history. It’s true sentiment can shift quickly in markets, and ahead of changes in the real economy, but the factors which explain that might not dissipate any time soon. Those still invested in UK plc have exhibited remarkable forbearance in recent years, but they may yet have to exercise more patience before there is a turnaround.

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