Over the past three years the FTSE All-Share Index has risen by 40%, beating the FTSE World index by 5%. Yet, no one cares. Despite the outperformance, the UK market trades at a significantly larger valuation discount versus the global index than it did three years ago. Would-be investors continue to shrug; UK outflows continue.
What’s going on? Is cheapness insufficient? Decent past performance not enough of a confidence booster? It appears that way. Some investors we speak with seem put off by the market’s cheapness – preferring to stick with the ‘reassuringly expensive’ US market. Others worry that cheap often remains cheap. They want a catalyst. While we share their desire, relatively efficient markets aren’t usually so obliging. Investing rewards risk-taking and the choice often boils down to ‘buy cheap and wait for a catalyst to appear’ or ‘pay up for an asset with a visible catalyst’. The have-your-cake-and-eat it option ‘cheap with a nailed-on catalyst’ is rarely on the menu.
Aware that no one needs to hear another UK equity manager bleating on about how incredibly cheap their home market is, what follows are two possible catalysts which could help unlock the UK market’s significant potential.
“The market does not turn when it sees light at the end of the tunnel. It turns when all looks black, but just a subtle shade less black than the day before.” James Montier, The Little Book of Behavioural Investing: How Not to Be Your Own Worst Enemy
Rotation
In the early stages of the pandemic the market consensus was firmly anchored to the view that rolling lockdowns would result in further disinflation and that bond yields would remain pinned to the floor. Asset valuations reflected this confident assertion, with ‘growth’ stocks riding high and ‘cyclicals’ falling behind. The ensuing inflation, bond market rout and growth-to-value rotation wrongfooted many.
The UK market was a relative beneficiary of 2022’s rotation towards value. Its mix of ‘defensive’ and commodity sectors proved themselves less sensitive to rising rates than many other markets around the world. As a result, the shorter-duration UK market finished 2022 in positive territory while longer-duration indices like the technology-heavy US NASDAQ lost a third of its value.
While not making a prediction, we see some parallels between the current market and that of early 2020. Once again, most investors seem confident that, one way or another, rates will soon come back down. US growth stock valuations are elevated. Should the macro once again wrongfoot the equity market and rates stay higher for longer, the UK’s value-tilted market should be a relative outperformer.
Reforms
Despite the UK’s heavy multinational bent, its domestic political odour has discouraged many would-be investors over recent years. Positively we sense change. A less chaotic political scene has created breathing space for policymakers to begin to address the multiple issues facing the UK market: a lack of natural buyers of UK equities, a dearth of IPOs, companies shifting listings overseas, vulnerability to foreign takeovers, and a host of other challenges.
While the Edinburgh Reforms of UK financial services, announced last December, show good progress, much more needs to be done. Most notably on the lack of natural buyers of UK equities. It’s curious that the UK has one of the largest pension markets in the world, yet domestic funds’ support for their home stock market is low. Research by thinktank New Financial shows that domestic defined benefit pension funds’ allocation to UK equities has fallen from 48% in 2000 to just 6% in 2020.
It seems that regulation designed to avoid risk-taking pushed typical natural buyers towards lower-yielding fixed income investments. While this certainly helped the government fund itself at low rates, it has arguably hindered the domestic equity market and those saving for retirement.
Announcements over the summer from the Chancellor, which encourage pension funds to invest in the domestic market, are an important first step in reversing the direction of the recent downward spiral. Speculation that the government could create tax advantages for investing in the UK, for example via a separate ISA allowance for UK-listed investments, could help further.
While none of the above is the nailed-on catalyst many investors crave, we are encouraged that the environment for investing in the UK market may become, by shades, a little less black over the coming months and years.
When you combine the above with the UK’s significant valuation discount then, in our view, the outlook for the much-maligned FTSE All-Share is better than it has been for many years.
