Investors have probably heard ad nauseam that the UK market is cheap, but so far, only foreign buyers and UK businesses have been listening and have taken action by initiating takeovers and share buybacks.
This increase in mergers, acquisitions (M&A) and buyback activity has often been cited as a potential catalyst for a market re-rating, but the cheapness and the emergence of the long-needed marginal buyer won’t do it on their own, according to Georgina Hamilton, co-manager of the £773m Polar Capital UK Value Opportunities fund.
Performance of fund against index and sector over 1yr
Source: FE Analytics
Starting from 2021, the UK has suffered a significant, multi-year de-rating versus international stocks. The price-to-earnings (P/E) ratio of the average FTSE 250 company was 11x in September 2024, against 22.3x for the MSCI World index.
To Hamilton, this gap was mainly due to two factors – the elevated cost of capital in the UK versus other countries and weak profit delivery, both of which must be resolved for the UK's comeback to be sustained.
“Frankly, if a discount rate keeps rising and if the cost of capital is very elevated, it's impossible for a country to re-rate,” she said. “And similarly, it doesn't matter how cheap a P/E is, if your E keeps getting downgraded, then no one cares. It's absolutely essential that those two issues are resolved.”
Luckily, there is still hope for fans of UK plc.
The first factor of the equation, the elevated cost of capital, derived from a more acute and persistent inflation problem in the UK compared to the US and Europe. Paired with political uncertainty, this was “absolutely damaging” and led the UK’s cost of equity and forward-rate expectations to spike.
But in 2024, the situation started to turn around. The UK inflation rate has fallen faster and harder than in any other country, leaving the UK “not necessarily in a great position, but a better position”, Hamilton said.
“Most things in life are relative and much like running away from a bear, you don't need to be faster than the bear, you just need to be faster than the competition, and the UK is in a relatively better position now.”
As for the profit weakness, her hopes are tied to GDP growth, which she was confident would come to fruition through more than one route.
First, a positive real income story is unfolding.
The chart below shows the amount of money that UK consumers have left after paying all non-discretionary bills. “You can see a really awful patch of very heavily negative real incomes, the likes which we haven't seen for a long time in the UK,” the manager noted.
“As a consequence, the UK GDP was continually being downgraded through to last year, so that the UK found itself at the very bottom of the table of G7 countries.”
Year-on-year in Asda Income Tracker
Source: ASDA, Centre for Economics and Business Research
But that has come a long way, with a 0.01% expected real GDP growth in 2024 being updated to the current 1.1% by the International Monetary Fund.
Second, savings could also spur GDP growth. Britons have squirrelled away 10% of their disposable income – a much higher savings ratio than other countries. This should positively charge growth if and when it translates into spending.
“Were that savings ratio to start to come down towards a normal rate of 7% or 8%, it would cumulatively add about 3% to 4% to UK GDP growth,” Hamilton calculated, which “could really accelerate the UK growth story”.
The same goes for mortgages. The refinancing headwind is very problematic for the UK, and “really sucks some of the growth out or certainly dampens the growth rate”.
If mortgage rates were to come down towards 4% (which they should do, as rate cuts start to come through), “that could really ignite UK growth more meaningfully”.
Now, all of that growth needs to translate into earning growth for it to be meaningful for investors, but Hamilton is leaning on the fact the FTSE 250 companies “have a very good track record of growing their earnings”.
“We have a lot of confidence that the GDP growth story, the positive real income story and more positive consumers’ confidence are going to feed through into earnings growth, and that will be one of the things that drives a re-rating of the FSTE 250,” she concluded.