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Challenging the prevailing narrative
Recent geopolitical and geo-economic events have given rise to a raft of new normals for investors. The COVID-19 pandemic, Russia’s invasion of Ukraine and ongoing US-China tensions have brought the era of easy money to an end and created an investment landscape defined by inflation, high interest rates and volatility.
This is a genuinely global phenomenon, yet for the UK – perhaps uniquely – it is in many ways a protraction of a negative narrative that was already firmly established. Investor sentiment around the world’s fifth-largest economy has generally been dismal since 2016, when the vote for Brexit signalled withdrawal from the European Union.
Whether such a bleak view was ever entirely justified is debatable, but there is scant worth in dwelling on the possible mistakes or injustices of the past. What matters is the reality of the present, which is that UK equities remain notably undervalued versus their peers – particularly those in the US.
Published at the height of the COVID-19 crisis in early 2021, one study described valuations as “implausibly low” and dubbed UK equities “the trade of the decade”1. Leading investment strategy firm Research Affiliates, which produced the analysis, doubled down on its claim earlier this year2.
This alone suggests this is a market that is home to significant investment opportunities. Yet investors could be forgiven for clinging to the notion that politics and its eternal bedfellow, economics, will somehow continue to undermine the UK’s prospects.
After all, it was politics and economics – in the form of the Brexit referendum – that first invited downbeat assessments of UK equities seven years ago. And it is politics and economics – albeit on a global scale – that have helped ensure most investors’ attention remains focused elsewhere today.
It therefore makes sense to examine more closely the UK’s political situation and its likely economic and – by extension – investment implications. Contrary to the doom-mongering that still pervades so many headlines, we believe the picture that emerges is encouraging. We argue that, far from being weakened, the case for UK equities is further strengthened.
Whatever happened to doomsday?
“It’s tough to make predictions,” Yogi Berra famously remarked, “especially about the future.” Psephologists, betting markets and investors have repeatedly proved this axiom, spectacularly miscalling major political events such as the vote for Brexit and Donald Trump’s ascent to the White House.
Nonetheless, it appears reasonable to make two basic assumptions in attempting to discern what might lie ahead for UK politics. The first is that the current government is very likely too damaged to benefit greatly from even the most dramatic turnaround in its fortunes. The second is that the next decade surely cannot be as unstable as its predecessor.
Like much of the rest of the world, the UK is now gradually returning to relative calm – “relative” obviously being the operative word. Let us quickly reflect on precisely how it stands.
Earlier this year the International Monetary Fund (IMF) warned the UK faced a recession and would experience the lowest GDP growth among the G7 nations. This turned out to be further proof of Berra’s typically mangled logic. The IMF now expects annual growth of 0.4% – which, although by no means earth-shattering, is markedly better than the 0.3% contraction originally forecast.
UK-EU relations are also looking up. The Windsor Framework resolved key disagreements on the implementation of the Northern Ireland Protocol and cleared the way for enhanced cooperation with Europe. The consensus on both sides seems to be that Brexit is finally “done”.
This enables the long-awaited unlocking of formal financial services regulatory cooperation. It also allows the resumption of talks on the UK’s participation in the EU’s Horizon programme of scientific research. Other acts of gentle reintegration are likely to follow.
Further afield, the UK has joined the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). This should open new markets for UK exporters and could also lead to cheaper imports of some goods. Business and Trade Secretary Kemi Badenoch touted the deal as the “clearest demonstration” yet of the UK’s freedom outside the EU3.
Will a General Election mean more upheaval?
All this constitutes a more promising state of affairs than the prevailing narrative frequently implies. Even so, with 2024 virtually certain to be a General Election year, the Conservatives have relatively little time in which to convincingly demonstrate the effectiveness of their economic policies.
Prime Minister Rishi Sunak and Chancellor Jeremy Hunt will almost inevitably try to seduce voters by dangling the carrot of tax cuts, but this may not be enough to keep the Tories in power. Despite concerns over Keir Starmer’s leadership, a Labour majority or a Labour/Liberal-Democrat coalition is more likely.
Would this herald a seismic shake-up from an economic and investment perspective? In other words, would Labour do things conspicuously differently?
On balance, probably not. Although a key lesson of the Blair years was that an incoming government should try to achieve as much as it can while it still enjoys popular goodwill, it is unlikely that a Labour victory would bring the sort of sweeping upheaval that could translate into a sizeable and detrimental impact on the markets.
Labour has already rowed back on its nationalisation policies. While some MPs urged Starmer to revisit the idea of nationalising water companies in light of the controversy surrounding Thames Water earlier this year, Shadow Chancellor Rachel Reeves has insisted returning sectors to public ownership “just doesn’t stack up against our fiscal rules”4.
Substantial banking reform also looks unlikely, although there could be an increase in the bank levy. In addition, Labour has stressed that keeping the UK’s financial services sector globally competitive will be “integral” to the party’s plans to enhance prosperity5.
The journey to a sustainable economy should also stay on track, with Labour touting a US-style public-private investment scheme to drive a “green revolution”6. The government is set to bring forward proposals for a UK Green Taxonomy in the autumn, but the electoral timetable should mean this initiative will not go live until after the General Election.
Further attractions and opportunities
We have discussed how the case for UK equities is rooted in their unusually low valuations. We have also explained why prospective political events are unlikely to derail the recovery of these undervalued stocks. What other considerations might be in our favour?
Inflation may be regarded as the elephant in the room, not least because persistently high levels have made the UK something of an outlier. Yet equity income can offer a solid defence against the erosion of purchasing power.
UK equities have long been acknowledged as an excellent hunting ground for resilient income streams. This is because a large portion of the UK equity market is found in dividend-paying sectors such as financials, energy and utilities.
It is also important to remember that many companies are essentially decoupled from the economy and able to grow more rapidly than GDP. To this extent, it might be said that a country is capable of running itself – not because of but in spite of politics.
With all the above in mind, we see opportunities in multiple sectors and across the market-cap spectrum. They include companies in more economically sensitive industries, such as Marshalls, the UK’s leading supplier of hard landscaping, building and roofing products; high-growth businesses where we believe the valuations have returned to more attractive levels, such as data analytics giant Experian and office space provider CLS Holdings; and financials, such as Lloyds, Barclays and HSBC.
Critics often bemoan the comparative narrowness of the UK’s technology sector. In the US, of course, the proliferation of Big Tech titans has regularly been responsible for the bulk of the S&P 500 index’s performance – as well as an array of stretched valuations. It is true that the UK lacks a line-up of mega-cap tech players, but it is hardly a tech-free zone.
One example is private equity and venture capital specialist Mercia, which invests in early-stage businesses at the cutting edge of science. Another is forward-thinking retailer Next, whose consistent outperformance of its peers has been in no small part due to superb use of tech in identifying and exploiting new markets.
Beyond the noise
On the whole, UK markets have now been a subject of negativity for seven years. In many arenas, particularly much of the mainstream media, this pessimism shows absolutely no signs of relenting.
As stated earlier, there is little to be gained from poring over whether such a woeful portrayal has been merited at various stages during this period. We can only ask whether it is deserved today – and we are firmly of the opinion that it is not.
Research Affiliates CEO Rob Arnott, a co-author of the “trade of the decade” study referenced earlier, recently observed that bargains always result from “the infliction of pain and losses”7. This is a fundamental corollary of how the UK has been perceived: equity valuations are uncommonly low.
In this article we have explored whether likely twists and turns in domestic politics might keep them low. To put it another way: are there potential developments on the political horizon which could thwart the recovery of these stocks in the eyes of the wider investment community?
We think not. While Brexit has been a drag on the performance of UK equities since 2016, the doomsday scenario that many “experts” prophesied has not materialised – and in many ways the UK’s political situation now looks more stable than it has for some time.
Whatever it might be, even the outcome of the forthcoming General Election should not bring a renewed sense of gloom. A change of government appears likely, but this need not mean radical economic disruption. We should also not forget that many businesses are pretty much unaffected by political happenings in any event.
The bottom line is that the UK is in far better shape than it is routinely given credit for. We expect the positive trajectory to continue, and we believe investors who ignore the “noise” and make informed decisions will be well placed to benefit over the long term.