UK equities: Things can only get better?

What is your outlook for the UK economy?

Things are getting better. There has been a reduction in income tax and national insurance as a percentage of earnings, and average earnings growth is above inflation. In addition, household cash flow is expected to increase by around 10% this year¹ and the next inflation print should be just over 2%. The Bank of England raised its forecast for UK economic growth, and in both continental Europe and the UK interest-rate cuts are set to come soon. Finally, investment spend is also on the rise.

How is UK merger and acquisition activity looking?

Bids for UK-listed companies in the year to date (28 May 2024) were US$77bn whereas last year the total bid count was just US$25bn,² with interest mostly from overseas buyers. Normally if you have an undervalued market relative to overseas you are going to start to see more bid activity either from private equity or overseas players. We have started to see that.

Is the UK still cheap relative to other equity markets?

The UK is still cheap. At around 11x earnings on a 12-month forward price-to-earnings (P/E) basis, the UK is at the lower end of its range over the last 20 years.³ This is in stark contrast to the US which is on 21x earnings on a P/E basis.⁴ In the US, ‘big tech’ is trading well above its long run average. Heavy flows into the US equity market have been driven by artificial intelligence (AI) optimism, but in many cases that enthusiasm looks to be priced in.

The result of all this is that tech valuations in terms of P/E are off the scale relative to history. AI is probably a positive, but will it monetise in the way it has been assumed in valuations? I would say not. You have an expensive US market, expensive tech, momentum-driven retail flows, and a lot of tech company directors selling shares.⁵ When viewed together these are cautionary signals.

Who owns UK equities now?

UK equities are under-owned by domestic asset owners. UK pension funds have an average allocation to domestic equities of just 2.8% – a sharp contrast with Japan where the figure is 49.8%, and with the US where it is 63.5%.⁶ This is despite the UK and Japan occupying similar weights in the MSCI World index, of 4.5% and 4.4%, respectively. There is a government-led effort underway to get more people to buy UK equities⁷ and pension funds are under pressure to increase allocations.⁸ The fact that more UK stocks are held by overseas rather than domestic investors is unusual, and highlights we are at rock bottom when it comes to exposure in the UK. Hopefully, this will be a trigger for things to improve.

Who are the potential new buyers of UK equities other than the companies themselves?

The fact that Europe and the UK are expected to cut interest rates before the US means there will potentially be more interest from the US in buying UK equities. We think that trend will continue for both the UK and Europe. We also think the marginal buyer from overseas is becoming more positive. Foreign investors took a step back because of Brexit and the situation in Ukraine, but, despite the upcoming general election, we do not think political risk in the UK is particularly high because the main parties are relatively similar from a stock market perspective.

In terms of UK domestic buyers, they are coming from such a low base. They could be encouraged as they see their own market rise and be tempted to reverse their underweight positions. As mentioned, the government is pushing harder to stimulate domestic investment through the likes of British ISAs (individual savings accounts) and solvency rules, so that could offer some support. Meanwhile, the growth of defined contribution (DC) pensions could also boost equities overall over time.

UK equity strategies sometimes invest a certain amount in overseas equities. Can you explain the rationale for this and why it is important?

We think this can provide access to the best global options and thematic and sector ideas that cannot be accessed in the UK. A current sector example is chemicals in Europe. With input from our team of global analysts and global income portfolio managers, looking overseas allows us to access best-in-class stocks while still focusing on our yield objectives.

That said, do you look at opportunities within the FTSE 250?

We do look at this area and do own some FTSE 250 stocks. However, liquidity in the FTSE 250 market is not as good as it was. Having the opportunity to invest outside the UK enables us to find attractive overseas stocks that are more liquid. That means we do not have to dip too far down the market cap spectrum.

What is your outlook for UK dividends?

We expect UK dividends to grow and rise more than inflation over the next few years, led by financials and energy stocks. UK equities offer attractive high yields that we believe are durable and will grow from here.

Where are you finding sources of income in the UK market?

We are looking to buy companies that are growing and that we think can outperform in an economic recovery. We have no exposure to utilities and we are underweight consumer staples as we think these still have defensive bond proxy characteristics which are unattractive in the current environment. We see more growth potential from financials like banks, as well as industrial stocks and oil where we see good distribution yields and expect to see both dividend and earnings growth.

Most income is coming from financials, industrials, materials, consumer discretionary and energy. These sectors are sensitive to economic growth, and I think earnings prospects are likely to improve rather than go in the other direction. Overall, we are positioning the portfolio to seek to outperform a rising market, and are aiming to benefit from what we think will be a recovery and economic growth as interest rates come down.

Do you see the recent upturn of bank stocks continuing? Could falling interest rates affect this?

The short answer is yes. Interest rates are likely to fall but bond yields should have already priced that in. It has been beneficial for banks to come out of the quantitative easing and zero-interest rate policy environment since the global financial crisis. I think bank returns on equity are durable, and if we get some economic growth coming through that could help loan growth. Furthermore, they have built up capital and are paying out high dividends with further buybacks to come. Overall, we think the bank rally has further to go. The key risk is an economic slowdown or recession. We do not see that happening in the short to medium term.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Sources:

1. Lazarus Economics, ONS, March 2024.
2. Deutsche Numis, May 2024
3. Factset, Goldman Sachs Global Investment Research, March 2024.
4. Ibid.
5. Business Insider. Nvidia’s directors bagged $80 million last week in a selling spree following the company’s blowout results. 29 February 2024; Bloomberg UK. Zuckerberg sold nearly half a billion dollars of Meta stock in last two months. 3 January 2024; QZ.com. Jeff Bezos has now sold billions worth of Amazon stock – and saved millions by moving to Florida. Updated 21 February 2024.
6. Capital Markets Industry Taskforce, 31 December 2023.
7. FT. ‘British Isa’ aims to boost ailing equities. 6 March 2024.
8. Gov.uk. Chancellor backs British business with pension fund reforms. 2 March 2024.

Authors

David Cumming

Head of UK Equities team