UK equity market revival
The UK equity market continues to languish at a c.40% discount to global markets. Commentators and investors alike have all but thrown in the towel. Some of the MSCI PIMFA benchmarks used to monitor our portfolios’ performance have recently reduced their UK weighting. Yet, I dare to suggest there is hope. Catalysts for a re-rating lurk in the shadows.
Winds of change
Explanations as to why the UK market remains cheap are well-rehearsed. An overweight exposure to ‘old economy’ sectors (at the expense of more highly rated technology companies), five prime ministers in eight years and the concurrent political challenges, onerous listing rules and obligations seeing many companies move to the US, a huge divestment in recent decades by pension funds of equities in general and the UK in particular, a perception economic growth has been relatively pedestrian, have all contributed to the malaise. Any good news has paled into insignificance. The bears have been rampant and have carried all before them.
A constant investment discipline is to question the consensus – outperformance cannot be achieved without deviation from the benchmark. In doing so, the journey is better informed if humility is your companion. In asking questions, one is always balancing sentiment and the fundamentals but also looking at the possible catalyst or catalysts which could spark a turnaround – even if it is a slow corner, and the ascent promises to be anything but fast. In doing so, I suggest the UK equity market appears to be in the foothills of what will be an enduring recovery relative to overseas markets.
Certainly, in contrast to the perception created in certain circles, economic growth has been among the fastest across the continent since Brexit, as evidenced by an unemployment rate remaining well below the EU average and inward investment continuing to compare well. The corporate sector is in good shape with company balance sheets strong and investment gathering pace. Personal taxes are higher than liked but one of the most generous furlough schemes and energy support packages ensured no one was left behind. Meanwhile, interest rates are now on the turn even though the Bank of England again risks being behind the curve in responding to the inflation outlook.
Perhaps another misconception should be tamed – the view that the UK market is bereft of technology. It is true the UK, like many other countries, is not home to the likes of the US’ magnificent seven companies. For some the jury is still out as to whether the lofty ratings afforded these companies are justified. Regardless, many large British companies are busy embracing technology and the application of digital tools, including AI. Examples include London Stock Exchange, Sage, Experian and RELX – and the price tags are disproportionately cheaper.
What of possible catalysts? In an increasingly uncertain world, the UK offers political stability. The election of a Labour Government contrasts starkly with far-right parties gaining political influence on the continent and the high stakes in the US presidential election. The Parliamentary system was always more robust and responsive than its detractors believe, but first past the post ensures the minority of extremists in our society, whether left or right, find it difficult to break into the political mainstream – proportional representation has conjured an ill wind on the continent. This is being acknowledged by international investors, who are also encouraged by the continued thawing in relations between the UK and EU.
The drive by City regulators to relax London’s listing rules, and so help stem the flow of companies moving to international rivals, offers hope. In the biggest shakeup in decades, rule changes simplify the process for companies coming to market including the elimination of the two-tier system of standard and premium listings, relax restrictions on dual-class shares to confer founders with more voting rights, remove the need for firms to provide a three-year financial record, and reduce shareholders’ rights regarding M&A decisions. Despite the governance concerns of some, the rule changes bring London more in line with international competitors. The regulation of the graveyard has little future.
However, more will need to be done. The Chancellor is looking to boost pension fund investment in the UK. This may involve consolidating the myriad of local government schemes into a model similar to that of Canada, which evidence suggests would encourage greater investment in domestic equities and infrastructure assets. The Government may also be looking at mandating the UK’s huge institutional pension funds to allocate a higher proportion of assets to domestic companies. Overseas pension funds certainly favour their domestic markets, and tax breaks confer responsibilities. Given the steep decline in UK exposure in recent decades, such changes would be a fillip to the market over time.
Perhaps another factor is worth mentioning. Current headlines focus on inflation falling and the speed of interest rate falls. Yet previous columns have highlighted the economic and geo-political forces which suggest inflation over the medium to long-term will remain higher than previously – with three becoming the new two. Although this is an improvement on recent years, given the implication for discount rates, it is high enough for questions to be asked regarding the lofty ratings afforded the larger US technology companies. Once the penny drops, investors will have another reason to look at the UK market.
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