25 Oct 2024
Hugh Gimber, Global Market Strategist | Zara Nokes, Global Market Analyst
This year’s cyclical upswing in the UK economy is another factor that could pique the interest of equity allocators.
Heavily discounted assets can typically be divided into two categories. There are those that are cheap for good reason, and there are those where low valuations represent a compelling investment opportunity over the medium term. Having underperformed global stocks in 24 of the last 36 years, the FTSE All-Share has increasingly been labelled as the former. Yet today, we see four key reasons why the UK market’s 40% discount to developed market peers is increasingly difficult to justify.
The sector composition of the UK stock market could shift from being a drag on equity performance to a tailwind. With the technology sector having contributed 32% of global equity returns since 2010, the FTSE All-Share’s 1% average weight to technology over the same period proved extremely problematic. However, with tech valuations stretched and the tailwinds for the sector likely to dissipate, the UK equity market stands to benefit from its tilt to energy and financials, given a renewed focus on energy security and a world where interest rates are unlikely to return to the levels seen in the previous decade.
Equity market sector weights
% of total market cap
Source: LSEG Datastream, MSCI, J.P. Morgan Asset Management. UK: MSCI UK; Developed market: MSCI World. Real estate is not included in these sector breakdowns due to the small size of the weight in each index. Past performance is not a reliable indicator of current and future results. Data as of 8 October 2024.
2022 serves as a recent reminder that the UK’s sector mix can at times be a strength. Following Russia’s invasion of Ukraine and the inflation spike that ensued, UK equities were one of the few major assets across either bonds or equities to eke out a positive calendar year return, as energy and mining companies acted as a diversifier. Whether it’s concerns around more cost shocks, rich multiples on technology stocks, or the prospect of bond yields being driven higher by fiscal largesse following the US election, the UK’s sectoral mix could see investors increasingly turning to the market for its diversification potential.
A shift in corporate behaviour should provide valuation support. It is widely understood that UK companies pay a healthy dividend, with the dividend yield on the FTSE All-Share averaging 4% over the past 10 years, in comparison to 2% for US companies in the S&P 500. More recently, however, buybacks have also picked up, suggesting that chief financial officers of UK-listed companies themselves view their shares as too cheap. UK buyback yields now exceed those in the US market, with the FTSE All-Share offering a current cash yield of close to 6%.
Buyback and dividend yields
% yield
Source: Bloomberg, FTSE, LSEG Datastream, MSCI, S&P Global, J.P. Morgan Asset Management. US: S&P 500; Europe ex-UK: MSCI Europe ex-UK; UK: FTSE 100; EM: MSCI EM. Chart shows yields for the last quarter in which buyback data is fully available. Net buyback yield adjusts for share issuance. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 8 October 2024.
Accelerating merger and acquisition (M&A) activity should be another supportive factor for valuations. The first three quarters of 2024 saw 19 transactions announced for FTSE 3501 companies, versus just two transactions in the entirety of 2023, according to data from Peel Hunt. The fact that more than half of these bids came from overseas suggests that sterling’s relatively low valuation may also be playing a role. The premium that bidders are willing to pay is equally notable: this year’s bids are on average 42% above companies’ market value prior to announcement.
For equity investors, clearly the current elevated level of M&A activity is something of a double-edged sword: short-term valuation support must be weighed against the long-term opportunity set. If all of the transactions announced year to date are completed, companies representing around 10% of the total value of the FTSE 250 would have left the market in just nine months. This trend is not new either. The number of listed companies in the UK fell by about 40% between 2008 and 2021, according to UK government data.
As a counterweight, recent actions taken by policymakers are seeking to encourage new listings on UK bourses. In July 2024 for example, the UK’s Financial Conduct Authority (FCA) proclaimed its new set of simplified listing rules as the largest change to the listing regime in more than three decades.
More broadly, the new Labour government has committed to undertake a review that will consider the further steps required to increase investment in UK markets. UK pension fund allocations to domestic equities are one area that has already received particular attention. Comparing UK pension asset allocations to 12 other developed pension systems around the world, UK schemes exhibit a home bias to domestic equities that is roughly two-thirds smaller than their regional counterparts, according to data from New Financial.
Pension asset allocations
%
Source: New Financial, J.P. Morgan Asset Management. *'Home bias’ is calculated by dividing domestic equities as a % of all equities by the weight of the local stock market in the MSCI investable world index. Data as of 8 October 2024.
Any prospective policy changes will need to be handled carefully. Attempts to mandate domestic equity investment would need to be balanced against pension members’ interests, and risks overlooking significant existing allocations to private UK assets, for example. Yet more broadly, policy risks appear more likely to be tailwinds for the market than headwinds over the coming years.
This year’s cyclical upswing in the UK economy is another factor that could pique the interest of equity allocators. With headline inflation moderating and nominal UK wage growth firm, real wage growth has been in positive territory for 13 consecutive months, easing cost-of-living pressures for some households. Business surveys point to resilience across both the manufacturing and services sectors, while the Bank of England has already started to ease its foot off the brake, with further rate cuts anticipated over the coming months.
Admittedly, UK growth momentum has softened a little in the past few months, with anxiety around the upcoming budget weighing on consumer confidence. However, as outlined in our recent On the Minds of Investors, the prime minister has explicitly ruled out a “return to austerity”. If tax rises target the redistribution of wealth towards lower income cohorts, this may even be net growth positive given lower income households have a higher propensity to consume. Recent public sector wage increases could add a further tailwind to growth.
UK Purchasing Managers’ Indices (PMI)
Index level
Source: Bloomberg, S&P Global, J.P. Morgan Asset Management. A PMI score of 50 indicates that economic activity is neither expanding nor contracting, above 50 indicates expansion. Guide to the Markets - UK. Data as of 8 October 2024.
Given the international nature of many UK corporates’ revenues, improvements in the domestic economy are much more likely to be felt by companies lower down the market cap spectrum, though even the FTSE 250 generates around 50% of its revenues overseas. Yet ultimately, a more positive macro environment, coupled with relative political stability, provides a stable landscape for international investors to consider.
Time to reconsider the UK equity market
Cheap assets can stay cheap for a long time, or worse, get even cheaper. In our view, however, current discounts in the UK now appear to have run too far. With a domestic recovery underway, corporate activity limiting further downside to multiples, and the potential for supportive policy changes ahead, now may be an opportune time to reconsider the prospects for UK equities.
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