At the start of this year, a difficult period for the UK appeared to be drawing to a close. Stock market confidence was recovering, merger, acquisition and share buyback activity was building, the economy was improving and a new government had ushered in a new era of political stability.
This optimism has ebbed since the summer: the realities of the UK’s fiscal position and fears over tax changes in the budget have deterred investors. Is the recovery at an end, or just on pause?
It is possible to paint a relatively gloomy picture of the UK economy. Talk of ‘black holes’ in the government’s finances has left investors worried as to the measures that might be needed to address the deficit.
The gap between the election and the Budget was filled with speculation about possible changes to capital gains tax, inheritance tax, pensions and employers’ National Insurance. This did little to improve confidence in UK economic growth.
Equally, while the UK economy is growing, its growth over the three months to August is slower than at the start of 2024. It is certainly not growing fast enough to address some of the fiscal challenges faced by the new government, nor to create the rising tide that might give UK companies a natural boost.
UK economy vs UK stock market
The fortunes of UK companies are influenced by a broad range of factors, of which the health of the UK economy is only one part.
UK companies operate all over the world. Over four-fifths of the sales of FTSE 100 constituents now come from outside the UK. Small and mid-cap companies are more domestic in focus, but even the FTSE 250 draws around 55% of its revenues from outside the UK.
That said, perceptions of UK weakness can influence the valuations attributed to shares. The UK stock market has suffered persistent outflows and this has left valuations low. Even taking into account its sector mix (more ‘old economy’ companies such as banking and energy, and fewer technology-focused areas), we believe UK companies are priced lower than their peers in other countries.
This looks out of step with the performance of many British businesses, which continue to compete well in global markets and generate strong earnings and cash flow. There is plenty to interest someone investing for growth.
FTSE dividend yield appears encouraging
The UK market is also a fertile source of dividends. Companies in the FTSE All Share index currently have an average dividend yield of 3.6%. This compares favourably with other major countries. The dividend yield for the US market, for example, is 1.3%, for Japan it is 2.2%, while for Europe it is 3.1%.
Even companies in the FTSE Small Cap index – not traditionally a hunting ground for those investing for income – have an average dividend yield of 4.2%. While investors need to be selective, income investors have a breadth of choice in the UK market.
Dividend growth
Those dividends are also growing, which is important for long-term investors who want to grow their income over time. Certainly, there were areas of weakness, such as the mining sector, but dividend growth is evident across a range of sectors.
Computershare expects UK dividends to continue to yield around 4% this year. We believe this is particularly important at a time when interest rates are falling and pushing down the income available on cash savings.
Interest rate changes
Interest rates in the UK are changing. In our view, a different interest rate environment may change the market mood. The era of loose interest rates flattered high growth companies, such as the technology giants. We believe that interest rates may come down but are likely to be structurally higher from here and this may change investor priorities.
International interest from corporate buyers in UK companies
There has been plenty of interest in UK companies from international private equity and from other companies. There have been bids for high profile UK companies, including Rightmove, Royal Mail and Hargreaves Lansdown. Bids for UK companies have been happening at a rate of around one per week over the past 12 months.
Equally, companies large and small have launched significant buyback programmes. This appears to show that the corporate sector, and the companies themselves, see value in the UK market today.
A stock by stock approach
The factors listed above appear to be supportive for the UK market. However, the biggest concern is continued outflows among retail investors. UK funds can’t seem to catch a break and Investment Association data continues to show investors withdrawing money from the UK All Companies sector.
There appear to be signs of institutional interest, but it is piecemeal. This needs to turn around before there can be a sustained recovery in the UK market as a whole. However, it does not mean that individual companies can’t perform well.
Ultimately, we believe value will be uncovered in the UK’s strongest names even if the market remains out of favour, and there is plenty to appeal for investors looking for income and growth.
Our focus is on forensic analysis of a company’s market position, management team, accounts and balance sheet to uncover those companies that can thrive, even if confidence doesn’t return to the UK. Nevertheless, we believe the signs are improving for the UK stock market.
David Goldman is co-manager of the BlackRock Income and Growth Investment Trust. The views expressed above should not be taken as investment advice.