A sequence of events over recent years, ranging from political uncertainty to rising inflation and interest rates, have led to uninspiring returns from UK equities. Given this backdrop, many investors have voted with their feet and switched their equity exposure to those markets with greater prospects for growth such as the US, or those which offer greater diversification globally.
Indeed, the latest available figures from the Investment Association confirm that retail investors pulled some £858m from UK funds in June this year.
Despite the negative view of UK equities held by many market participants, we believe there are numerous reasons which support the inclusion of UK equities within investment portfolios, not least owing to their significant undervaluation.
The UK market is currently cheaper both relative to its historic average and to most other comparable developed markets, a symptom of the headwinds the UK has faced.
Should these headwinds dissipate, for instance, if there are signs that inflation is continuing to come under control or if the Bank of England signals the end of interest rate rises, the economic outlook would improve markedly.
An upward revision of corporate profits that would result from a more benign economic environment would drive share prices from their current lows, heralding a rebound in the market. And while there is no certainty over when we will see an improvement in economic conditions, the low valuations of the UK market mean they present an opportunity for investors willing to take on some risk, at least over the short term.
We are also sympathetic to the view that there is a mismatch between the performance of UK firms and that of the market as a whole. UK-listed companies have recorded strong year-on-year earnings and revenue growth for several years, while the market has remained broadly flat over the past three years.
This view is supported by a number of UK managers we invest in who see the pessimistic valuations of UK stocks as being at odds with optimistic corporate earnings growth. Indeed, they note that the companies they hold have demonstrated remarkable resilience, despite the prevailing market backdrop. After all, many of the UK’s largest companies that have survived numerous global events are mature and well-managed.
Much has been written on the impact of the cost-of-living crisis on consumers and how those with fixed-rate mortgages will be forced to tighten their belts as their existing deals come to an end.
However, an important characteristic of many British companies is that, while they may be listed in the UK, the bulk of their revenues are generated internationally. Indeed, more than 70% of the revenue of companies listed on the UK stock market comes from outside the UK, making them less correlated to the sluggish UK economy, and therefore less exposed to the UK consumer. This should make them compelling for those who want to access global growth through established UK names.
Beyond this, some managers we have spoken with have pointed to the increased political and regulatory commitment to address the issues that have reduced the appeal of the UK as a place to list and raise capital from markets.
As evidence of this, the UK government is attempting to make the UK market more attractive to investors by incentivising large pension funds to reinvest back into the market through potential tax breaks, while reducing the regulatory burden on UK-listed companies and promoting the market overseas.
This may well breathe life back into the UK and help it regain its position as a preferred domicile for those coming to the market.
The burning question, and one which many UK equity managers are looking to answer as they continue to grapple with a troubling market, is what the catalyst (or catalysts) will be to trigger a prolonged market rebound.
It may be that investors regain confidence in the UK market once they see the Bank of England signal that inflation is under control by lowering interest rates. It could be continued strong earnings growth, or a political catalyst such as a cease-fire in the Ukraine, or simply a case of a rising tide lifting all boats, with the UK market benefiting as countries elsewhere grow strongly.
Whatever it is that triggers a reversal in fortunes, the view of many managers is that when a turnaround comes, it could be extremely rapid. Notwithstanding some level of short-term volatility, we believe that the potentially significant upside for those participating in a market rebound means that the investment case for UK stocks should not be ignored.
Matt Belcher is an investment manager at Square Mile Investment Consulting and Research. The views expressed above should not be taken as investment advice.