What is in the forecast for UK equities?

Last year was supposed to be different. The composition of the UK market, for so long a headwind owing to the lack of technology exposure, became a positive as investors clambered into oil and commodity stocks. 

That resulted in the FTSE 100 being the best-performing developed equity market in the world in 2022, but the outflows have continued, with more than £5bn pulled from various UK equity sectors to the end of April 2023.  

But with the economic outlook changing rapidly, what could be next for investors in the UK’s domestic market?

The evidence of optimism is actually there, because we can see that sterling has risen a lot.Alexandra Jackson, Rathbones

Alexandra Jackson, UK equity manager at Rathbones, says: “UK equities usually trade at a bit of a discount to the US, but the discount is now around 40 per cent, and that is hard to justify.

"I think the change will come simply from the memory of the stuff that caused the problems in the first place – the “mini”-Budget and the Northern Ireland protocol – receding into the distance. The evidence of optimism is actually there, because we can see that sterling has risen a lot.

"The FTSE 250 index typically trades alongside the pound, that is, they rise or fall together, but we are not seeing that now.”

Jackson notes that while the FTSE 100 did deliver a positive return in 2022, that was the consequence of big gains from 15 companies, with the other 85 components of the index being mostly in negative territory. 

The FTSE 250 was down in aggregate as well, which Jackson says is normal in times of market stress.

But her view is that when investor sentiment has improved a little, then the mid-cap index would be expected to outperform relative to the large-cap market. 

One reason why there may be a dislocation between the movement of sterling and the movement of the FTSE 250 is that the latter is gaining ground based on expectations of higher interest rates, but higher interest rates are not necessarily a positive for the wider economy. 

But if the economy’s health is robust enough to cope with rate rises, that should imply that UK-listed companies can benefit from the improved outlook. 

Nick Kissack, UK equity portfolio manager at Schroders, says that while recent political factors, including Brexit, have not helped sentiment towards the UK market, the discount relative to the US predates that – a factor he attributes to the composition of the UK market.

But he notes: “The new macroeconomic regimes globally, with a focus on higher interest rates and tighter monetary policy, actually suit the UK market.”

Abby Glennie, deputy head of smaller companies at Abrdn, says an indicator that the tide of sentiment is turning comes from the level of private equity investment currently being deployed in the UK, frequently to buy listed companies. 

Glennie says this is an example of the market signalling that, "if equity buyers won’t close the discount relative to other markets, then someone else will".

Jackson says that while private equity acquirers paying premiums for the UK companies they are buying helps to improve sentiment, “for the most part, so far, the companies they are buying are those in need of a turnaround, and the companies being left on the market are of a higher quality.”

The catalyst could simply be that investors start to notice they are missing out on returns.Alan Dobbie, Rathbones

Hugh Sergeant, a veteran UK equity manager at River and Mercantile, says that while the home market’s moment in the sun in 2022 was driven by a tiny number of stocks in areas such as mining, and while the outlook for those stocks in the short term is uncertain, he believes that what has changed for investors is that we are returning to more normal market conditions.

This follows a decade in which growth stocks did well in a time of very low interest rates and inflation. But those were the abnormal conditions; a world where there is some inflation and where interest rates are above zero is more normal and that world is one in which many of the types of companies listed on the UK market do better.

Alan Dobbie, co-manager of the Rathbone Income fund, says: “UK equity income funds have now performed relatively well on a three-year view.

"And the catalyst could simply be that investors start to notice they are missing out on returns, especially as they realise that the world of very low rates is one we are not going back to.”

He adds that while the UK market is associated with cyclical sectors, a feature of many corporate results has been the resilience shown by many of the large consumer goods companies during this period of inflation. 

The new macroeconomic regimes globally actually suit the UK market.Nick Kissack, Schroders

Those companies, for example Unilever, are sometimes referred to as bond proxies because the durability of their earnings resembles those of a bond.

Those bearish on companies such as those point out that as bond yields rise, investors just buy the bonds rather than the equities that resemble bonds, but also that consumers will respond to the prevailing higher inflation by trading down to cheaper brands.

But Hugh Yarrow, fund manager at Evenlode, says that “results have been resilient so far, and now we are in a position where thee input costs of those companies are falling back.” 

David Thorpe is investment director at FTAdviser