UK stock market outlook: The clouds over UK equities are clearing

In the last couple of years, the UK economy has weathered some of the highest levels of inflation, interest rates and political turbulence in decades. As a result, many international investors have sought shelter outside the UK stock market. The macroeconomic backdrop now appears to be stabilising and Labour’s decisive victory in the recent general election could provide a further catalyst for the UK equity market.

UK consumers start to spend

Economic indicators had started to look better before the election. Inflation is back down around the Bank of England’s 2% target, which is setting up expectations for the central bank to begin cutting interest rates. GDP growth turned positive again in Q1 2024, purchasing managers’ indices are expansionary and the job market remains strong, supporting wage growth above inflation.

All of these factors are contributing to an improvement in UK consumer confidence. While a healthier and more confident UK consumer is not yet reflected in retail sales figures—and big-ticket sales will be slower to recover—we believe this is a turning point and consumers will start to spend more. Our UK equity investment trust portfolios are positioned across a number of consumer-oriented UK companies, including a sustainable food producer and a low-cost airline.

One industry that is very likely to benefit in this environment is housebuilding. In addition to lower inflation and the potential for lower interest rates, we expect to see mandatory home building targets and some planning policy reforms. We actually met with the management team of one homebuilding company that views the new government as one that actually wants to build homes. Many of these companies still trade below book value, which sets up the potential for revaluation as growth returns to the sector. 

Investors return to UK equities

Many UK insurers and pension funds are underweight their home market—an anomaly compared to most countries—with UK equity allocations of 2.5% – 3.0% range vs. the 4.0% UK weight in the global index. The Labour government supports the drive to increase pension allocations to UK equities outlined in the Mansion House Reforms and we believe movement in this direction is likely to begin soon.

UK small cap funds have been seeing inflows since September and, more broadly across UK equities, outflows appear to have stabilised in recent months. We believe many investors have been waiting to get past the election before increasing allocations from current low levels. The UK stock market rose over 1% right after the election, and we also note increasing interest from investors outside of the UK in gaining exposure to the UK market. 

M&A activity has increased

Merger and acquisition (M&A) activity is 60% higher than last year, with bids for UK companies announced almost every few days. So far in 2024, 72% of takeovers are led by corporate buyers, a change from last year when most buyers were private equity funds, which indicates that corporate management teams are also feeling more confident.

Companies are being bought at roughly a 30% – 40% premium, on average, which can boost performance, particularly in small cap portfolios. The risk for shareholders of the acquiring companies is that valuations for many UK companies have been low, given the recent challenging macroeconomic environment, so portfolio managers try to engage with managements to make sure that companies are sold at fair valuations.

Initial public offerings (IPOs) of UK companies were rare in 2022 and 2023 after a record year in 2021. However, we see signs of activity again and expect a more stable post-election political backdrop to be helpful.

UK companies continue to pay high dividends and buyback shares

With roughly a 4% dividend yield, the UK equity market has always been one of the highest yielding stock markets. The current dividend yield of about 4% is roughly double that of the MSCI World Index and triple the S&P 500 Index, which is notable given the recent recession and increase in share buybacks. Lower share counts should help the UK’s dividend yield to grow even faster.

Our small cap portfolio managers don’t tend to favour share buybacks due to concerns about liquidity and the general view that small, growing companies typically have better uses for their cash. However, valuations at current low levels have temporarily changed the equation and buybacks currently look highly attractive.

Conclusion: Confidence is returning

The challenging environment for UK equities over the last few years has prompted some investors to question their allocations. We believe a new era of government stability, combined with improving economic trends and attractive valuations, should provide a clearer answer to those questioning the benefits of investing in the UK stock market.