
Stalled optimism: navigating UK stock market uncertainty
Just a few months ago, it was all looking so good for the UK. Stock markets were rising, interest rates were falling, and the economy appeared to be bouncing back. Political stability seemed to have returned after a decisive election and there was optimism that a new era may be starting. That optimism may have been premature.
Since the summer, the UK stock market has faced a number of headwinds. The uncertainty surrounding the Autumn budget has led investors to sit on their hands. The apparent political stability has proved largely illusory as the incoming government has faced accusations of cronyism and mismanagement. Economic recovery has stalled, and while there has been a single rate cut, the Bank of England is now lagging the Federal Reserve and the European Central Bank in scale and speed.
The strength of sterling, a feature of the post-election period, has also been a problem for some parts of the market. Richard Hallett, manager of the IFSL Marlborough Multi Cap Growth fund, says it has been a particularly tough environment for the type of business he invests in: “We are looking for companies that do something different, that are changing industries. These businesses need to be globally competitive. After the election, sterling rose for the first time in five or six years. International growth businesses in the UK fell out of favour as a result.”
He says that the only real winners have been domestic companies linked to some of the initiatives of the new government. These are areas such as infrastructure or building materials, likely to benefit from planning reform. The wider property sector may also benefit from lower interest rates, which appear to have stimulated demand in the housing market.
This is not to say it’s been awful: the recovery may have stalled since the summer, but the FTSE 100 remains above the Nasdaq over the past three months, and the FTSE Small Cap is higher still. It may not be the rally that many had hoped for in the giddy early months of 2024, but there is some hope that momentum could revive if the budget is not as onerous as the more pessimistic predictions suggest.
Victoria Stevens, a manager on the Liontrust UK Smaller Companies and Liontrust Special Situations funds, says that the direction of fund flows is likely to be critical for the UK market from here. “Much of the reason the UK has been so weak in recent years is basic supply and demand. There has been a structural flow headwind of larger investors continuing to allocate away from the UK for a number of years, creating a doom loop.”
Retail investors continue to shun the UK. Another £629m left UK All Companies funds in August, after £654m left in July*. The latest report from Calastone painted a similar picture, with UK funds seeing outflows of £666m in September, the only major market to see outflows over the month**.
None of this paints a particularly encouraging picture, but Victoria says anecdotally investors seem to be coming round. Although outflows from retail investors continue, there appears to be growing interest from institutional investors, with BlackRock and Allianz raising their exposure in recent months.
Equally, abundant merger and acquisition activity continues to buoy the market. There have been bids at a pace of over one a week over the past 18 months, including high profile companies such as Rightmove, Hargreaves Lansdown and the Post Office.
There is also the buyback factor, which is a feature across large and small-cap companies. Nick Kirrage, manager on the Schroder Income fund, points out that the UK has the highest total return yield (i.e. dividend yield and buyback yield) of any major market. This, he says, “makes it a lot more difficult to lose money.”
This suggests that corporate/private equity buyers and companies themselves believe the UK is undervalued. Richard says that companies in the UK remain at a 20-30% discount to their equivalents elsewhere. The worry is that this activity hollows out the market even further. There is still no revival in the IPO market, which would help replenish it. That said, it is usually a lagging rather than a leading indicator, only starting to get going once the stock market has revived.
If investors do believe that a turnaround is imminent, which segment of the market would be the better choice? When money flows into a market it tends to go to ‘the market’ first, says Victoria, so larger companies tend to see the greatest benefit. This has been seen in Japan, much to the irritation of small and mid-cap managers who believe there is far greater value elsewhere.
Nevertheless, says Victoria, the small-cap premium is real – over a decade they have outstripped large-caps by 3x. The problem is that small-caps can be volatile. They have been flashing as good value for some time, and buying when they are at a low point has generally been a smart idea. However, this has been a particularly difficult cycle to judge and the turning point has proved elusive. Victoria says that if they turn, weak liquidity means they may turn very fast, so investors need to be in it ahead of time.
Richard is finding value across the market. Among the large-caps, he sees value in companies such as Experian, or LSE, both of which have large data sets. They can interrogate this proprietary data using AI to deliver better insights to their clients. Within the mid-cap companies, he holds JTC, a back office support services company, whose clients include regional asset managers, hedge funds, pension funds and private client fund managers***. It is a steady business, growing organically, says Richard. Among the small-caps, he likes software business Craneware, which serves the US healthcare system***.
The UK is on a long, slow, bumpy path to recovery. Providing the Autumn budget isn’t too scary, the Bank of England plays ball, and nothing too dramatic happens in the economy, the UK market should be able to find its feet again.
*Source: Investment Association, full figures, August 2024
**Source: Calastone, fund flow index, October 2024
***Source: Marlborough, 1 October 2024