Franklin Templeton: UK Equities - Attractive Relative Valuations, Despite Relatively Unattractive Macro Signals

Inflation, energy prices, interest rates, wage pressure, supply chains, COVID-19 third wave—there are a number of issues weighing on investor sentiment in the United Kingdom. However, we believe there are several positive indicators that counter these headwinds, such as a well-capitalised consumer with pent-up household savings, a sharp rise in initial public offerings (IPOs) and merger & acquisition (M&A) activity, and attractive valuations compared to the rest of the world.

UK Market Valuation Discount Has Widened

FTSE All Shares Index Vs. FTSE All World ex-UK Index Forward P/E

For 10 Years Ending October 2021

The price-earnings (P/E) ratio is an equity valuation multiple defined as market price per share divided by annual earnings per share. For an index, the P/E ratio is the weighted average of the P/E ratios of all the stocks in the index. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance.

Source: Macrobond, as at 31 October 2021. See www.franklintempletondatasources.com for additional data provider information.

As we move past what is likely the most acute stage of the COVID-19 pandemic, the second-order effects of this recovery are beginning to cause concern for investors.

Stagflation (high levels of inflation but low economic growth) has become a potential scenario. As economies have reopened, supply-chain bottlenecks and rising commodity prices have caused pockets of severe inflation (such as used car prices rising 18.3% year on year)¹ as supply has not been able to keep up with excessive demand. In the United Kingdom, rising energy prices are likely to drive inflation higher into next year.

A specific point of contention is the increase in the energy price cap in spring 2022, which could see energy prices rise by 30%-40%, adding as much as 1% to inflation. We see this, along with higher levels of taxation through national insurance contributions, as examples of how the potential exit rate of growth from the pandemic may not be fully achieved.

Labour costs are undoubtedly the greatest challenge to our view of inflation. The unemployment rate at 4.5% (as of August 2021) is testament to the effectiveness of government policy during the pandemic, but we remain vigilant as to how the employment backdrop evolves going into 2022 as the furlough scheme is wound down.

Amid firming prices, central banks globally have taken a more hawkish tone, though this may not translate into policy changes. The Bank of England (BoE) has a somewhat different policy framework than the US Federal Reserve (Fed) and European Central Bank (ECB). The Fed and ECB target an average rate of inflation of 2% over the cycle, whereas the BoE targets an explicit 2% level, making it more justifiable to raise interest rates in the United Kingdom. As of October 2021, the market-implied base rate a year forward is around 80 basis points, from a current level of just 10 basis points. With UK gross domestic product 3% below its pre-pandemic peak, and with a raft of fiscal tightening measures on the horizon, we see considerable risk that simultaneous monetary tightening may derail any further recovery.

The definition of “transitory inflation” continues to be stretched, but we believe the bulk of inflationary pressures seen in the current data is temporary, and that forecasts for inflation as high as 7% for 2022 will prove excessive. Elsewhere, we have been surprised by the increased government intervention in the United Kingdom across the private sector as the pandemic has subsided. We see this as a harbinger of risk should it continue. There is a limit to how much a government can step in to help failing companies and sectors. In our opinion, reducing competitiveness in an economy rarely results in the effective allocation of resources and beneficial outcomes over the longer run.

Despite these risks, we believe the UK consumer is well-capitalised to abate rising energy prices and interest rates. Through the pandemic, consumers have built up savings which are yet to be deployed. A BoE survey (see below) indicated that the majority of investors plan to continue holding onto their savings in the short term, but we expect to see this money flow back into the economy through the remainder of 2021 and into 2022.

Deployment of Excess Savings a Key Variable

Planned Use of Funds Among UK Households with Increased Savings

September 2020 Vs. March 2021

Source: Bank of England 2021 H1 NMG Household Survey and Bank calculations.

Another positive indicator is a significant increase in market activity as we move past what is likely the most acute stage of the pandemic. By the end of the third quarter 2021, UK equity markets had seen the highest rate of IPOs since 2014, with a quarter of the year still to go.² While this is partly due to a backlog of postponed IPOs through 2020, it indicates that risk appetite is returning for both businesses and investors. We have also witnessed an uptick in M&A activity, which is typically a strong signal for equity markets as company valuations are perceived to be cheap and ripe for acquisition.

Turning our attention to valuations, we believe UK equity valuations are attractive relative to the rest of the world. Over the last few months, the valuation discount for UK equities has widened in terms of the price-to-earnings (P/E) ratio, providing an opportunity for active investors such as ourselves to initiate positions in high quality companies at discounted prices.

Looking forward, the UK Equity team remains cautiously optimistic that there are strong opportunities for investors in the UK equity space due to cheap relative valuations, and that headline risks are potentially being overplayed by the media.

CONTRIBUTORS

Ben Russon, CFA, Vice President, Portfolio Manager, Franklin UK Equity Team

Will Bradwell, Portfolio Manager, Research Analyst, Franklin UK Equity Team

What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile. Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.