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Will economic green shoots entice investors back to UK market?

Value stocks and smaller companies could benefit from a UK equity revival


Cherry Reynard

When Rishi Sunak gives assurances that the “plan is working” on the UK economy, the polls suggest that few are inclined to agree with him. However, there may be some green shoots for the UK economy. They may not emerge quickly enough to save the prime minister, but could it draw investors back to the UK market?

For the time being, the signs of recovery are not obvious from backward-looking economic data. There has been a tentative recovery from the technical recession in the fourth quarter of 2023, but GDP only rose 0.2% – nothing to excite investors about an imminent revival of UK fortunes.

However, forward-looking data paints a more interesting picture. Recent flash PMI data showed a strong end to the first quarter. S&P Global Market Intelligence said: “A further robust expansion of business activity ended the economy’s best quarter since the second quarter of last year. The survey data are indicative of first quarter GDP rising 0.25% to thereby signal a reassuringly solid rebound from the technical recession seen in the second half of 2023.”

The survey also signalled a fifth consecutive monthly expansion in business activity, with the services sector showing a sustained rise. There was also a small but symbolic return to growth for manufacturing output, which had contracted over the prior 12 months. S&P Global Market Intelligence said: “New orders placed at factories rose for the first time since last March. Although only marginal, the rise in demand signalled was the largest for 22 months, albeit with export orders continuing to decline.”

The IoD Directors’ Economic Confidence Index, which measures business leader optimism in prospects for the UK economy, also saw a sharp rise in March, having dropped back in January and February. The index of business leader optimism for the future of their own organisation rose to +42 in March, up from +37 in February. Also, net investment intentions for the year ahead jumped higher, important for an economy where business investment has been lacklustre.

Controlled inflation

Unlike in the US, this economic revival has, so far, come without an inflationary sting. Inflation is expected to come down sharply over the next few months, with the fall in the energy price cap a particular catalyst. There have been encouraging signs on food price inflation, which dipped below 2% for the first time in two years in March.

The stumbling block has been employment – but here too there was good news. The PMI survey showed the flash employment index dropping to the 50.0 neutral level. Further manufacturing job losses (albeit at a reduced rate compared to February) were accompanied by a near-stalling of service sector employment.

Wage inflation has been the biggest barrier to a fall in interest rates. However, recent Office for National Statistics data showed British wages excluding bonuses growing at their slowest pace since October 2022 while the unemployment rate edged up unexpectedly. This paves the way for an interest rate cut.

The UK economy still has vulnerabilities. Service sector inflation has been persistent and retail sales were flat in February after a strong bounce in January. There are still a lot of households coming off fixed rate mortgages that will see higher repayments. This will continue to put a squeeze on household finances.

Who wins?

There is a question of whether this stronger economic data would make a difference to the UK stock market – and if so, which areas would win. Clive Beagles, manager on the JO Hambro UK Equity income fund, is optimistic: “With UK savings ratios elevated relative to pre-pandemic levels, only a modest degree of monetary easing will likely be required to boost spending and activity materially.

“Just as important will be the impact this has on international and domestic investors’ views of the UK economy and, by association, the UK stock market. With UK inflation no longer an outlier in an international context and an economy that has the capacity to rebound reasonably sharply, the very low valuations on offer in the UK market will begin to attract fresh interest.” His value-focused fund has already seen a bounce.

Ben Arnold, investment director in value and European equities at Schroders, believes small and mid caps are also likely to be a key beneficiary. While their portfolios tend to be more large cap, he says they are running as high a weight to small and mid-cap businesses across the team that they’ve ever had. He adds: “Small and mid-cap valuations are very depressed and we know over the long term that they typically outperform large caps. This is a key theme across all of our strategies. When will they outperform? We don’t have that answer, but we just think the fundamentals are at odds with what people are willing to pay and that will improve over the next three to five years”

The prospect of economic recovery may be part of the reason trade and PE buyers are coming back to the UK market. Arnold says: “M&A is encouraging. We’ve seen some of our companies bid for over the last 6-12 months. We’ve had the bid for Currys, Direct Line, which pushed the shares higher. There’s quite a lot of bid interest into the UK from US private equity. Sometimes you don’t need the rest of the stockmarket to see the value you may see. There may be private equity or strategic buyers – a company sees another company is cheap and thinks they can incorporate that business.”

It has long been clear that cheap valuations are not enough in themselves to bring investors back to the UK market. However, a strong economy could be an important factor in the revival of UK equities. Previously unloved areas such as value and smaller companies look set to be the main beneficiaries.