If the UK stock market is cheap, why doesn’t it go up?

My earliest memory of watching a football match was the FA Cup Charity Shield final in August 2001, where Liverpool beat Manchester United 2-1.

My father and older brother supported Manchester United, so — a free agent at that point — I chose to root for Liverpool — and I’ve been a very lazy Reds fan ever since.

If I’d been biased by geography rather than naked contrarianism, I would have supported the local club, Coventry City, and yielded a substantially worse return on my (costless) investment of support.

The analogy is flawed, but it pays for British investors to think about this kind of geographic bias when it comes to their portfolios. If you were a true citizen of nowhere, unmoored from any particular Earthly plane, would you even think about putting your money into UK stocks right now?

At Alphaville, the FT’s markets and finance blog, we don’t do financial advice. But we read a lot of analysis, and spend time looking at lines on screens — so when FT Money asked us to do a health check on UK equities we agreed to give it a shot. 

So here goes: is it worth buying UK equities right now?

In the dumps

One reasonable answer is: absolutely yes. A Morgan Stanley analysis published last month found that core UK plc assets — equities and corporate bonds — “are arguably the cheapest asset classes in the world”. That position is particularly remarkable given the FTSE 100 was the best-performing major global index of 2022 (by staying basically flat).

This extreme position is, obviously, partly attributable to macroeconomic events. MS analyst Graham Secker blamed “extreme pessimism in the aftermath of the ‘mini’-Budget” for numbing markets to Britain’s expectation-beating growth performance, Meanwhile, sterling’s recent strength — up 5 per cent against the dollar this year — has put further pressure on the top-end of the FTSE, while deterring foreign investors. 

There’s also, as always, Brexit. UK equities’ plunge into record discount territory versus global stocks can be traced back to the referendum in 2016. On one crude indicator, price/earnings, FTSE 350 stocks were virtually equally valued to global shares on the eve of the referendum, with both at 18.6 according to Bloomberg data. Now they’re about half the price: as of last Thursday, the FTSE 350 had a price/earnings ratio of 10, while MSCI’s World Index stood at 19.8.

There is another, more questionable, buy indicator flashing: inverted yield curves (which are currently in effect) have historically been a good sign for UK equities. This is when the yield on a longer-date bond is lower than on shorter-dated paper, and sometimes suggests recession is coming. The FTSE 100 has historically tended to outperform under these conditions. You might find this encouraging — we think it’s a bit mushy.

Still, as Secker told clients: “UK equities have a longstanding reputation for offering relatively attractive valuations; however, poor investor sentiment towards the general UK macro backdrop for much of the past 5-10 years has arguably left them even cheaper than normal.”

There are some types of reputation that one should avoid maintaining. One of these is for having attractive valuations. So when the bargain bucket is this big, there must be something good in it — right?

Skimming the cream

Let’s look first at the top UK companies. In his analysis of US stocks for Money this month, Unhedged’s Ethan Wu said that — for long-term investors — there is “almost never a bad time” to buy US stocks. 

Across the pond, things aren’t quite so simple: the question isn’t so much when to buy — to which the answer is often “as soon as you can” — but why buy at all? 

If we follow the logic that seeking growth through broad passive investment via trackers is ideal because it is inherently hedged, cheaper and simpler, then top-end UK equities aren’t much to write home about.

Main-market UK equities have long been a tale of two types: the value-oriented internationals that are largely found in the blue-chip FTSE 100 — which make about 70 per cent of their revenues overseas — and the more domestically-focused mid-caps.

Morgan Stanley’s UK picks are mainly skewed towards bigger companies: BAE Systems, Ashtead, 3i, BP, Smith & Nephew, Haleon, Prudential, Rio Tinto, AstraZeneca, Invidior, Segro and SSE. Some are more embedded in Britain than others but, other than commercial property investor Segro and Scottish energy company SSE, they have fairly limited exposure to the UK’s domestic economy.

Credit Suisse’s picks, from April this year, are broadly similarly outward looking: Informa, RELX, Bodycote, Coca-Cola HBC, ABF, ITV, Elementis, Unilever, British American Tobacco and Imperial Brands. Its analysts see the UK as offering desirable “defensive value” — but that isn’t much of a long-term strategy.

So, identify the multinationals that are suffering from being in London. It all sounds well and good, but it’s more of a bet on the global economy than the British. If you want to follow the macro trends, you can do so without the UK’s idiosyncratic issues. Also, for lay investors timing these investments is tougher and the risks are inherently higher than buying into a whole index.

Look at the US: as well as the advantages the blue-chip S&P 500 derives from rich American capital markets, 2023 proves that sometimes just the top-end of US stocks are strong enough to carry the rest of the index on their backs. You can buy a broad US tracker and be pretty sure that you’re going to get better long-term returns than UK stocks, in aggregate, can offer. (But remember that past performance is not a guarantee of future returns, something that is especially true if you’re taking investment tips from a finance blog).

The UK is a tough sell. Sure, a mass improvement in the fortunes of London-listed stocks might happen this year or next, but something has clearly gone a bit wrong for performance to struggle for so long.

If you’re making the most important long-term, non-housing investment of your life — your pension — leaving yourself highly exposed to the UK seems like an unnecessary gamble.

Plus, if you want some defensive allocation to offset riskier assets in your portfolio, gilts, which are still carrying a risk premium that makes them more attractive than rivals from Germany and the US, is a better option. The only reason to worry would be if you think the UK is going to go bankrupt. Things haven’t got that bad.

Digging deeper

So what about Britain’s small- and mid-cap companies? Here, things start to look a lot more attractive. As Panmure Gordon’s Simon French pointed out in a recent note, the UK’s recent Mansion House compact “has set in motion those rarest of things — an expectation of structural inflows into [smaller UK equities]” .

Under that agreement, nine UK managers of defined contribution (DC) pensions funds (about two-thirds of the DC market) will aim to put 5 per cent of their funds into unlisted equities — that is, those off the London Stock Exchange’s main market — by the end of the decade. Material progress is expected (by the government, at least) in the next 12 months.

Assuming this project survives the likely routing of the Conservative party in next year’s general election, it should create some irresistible momentum among smaller stocks.

“The hope is that this triggers a virtuous valuation cycle that encourages investors to crowd in these flows, and growth companies to raise capital on UK capital markets,” says French — who called it a “small ray of light”.

Obvious beneficiaries are likely to be the Aim/Aquis category, says Panmure Gordon. It’s an area which deserves a Wild West reputation — the latest cautionary tale is the controversy at WANdisco, the data technology group, which is currently investigating potential sales fraud. Some of the groups Panmure identifies as likely to benefit are recognisable names. Alliance Pharma, M&C Saatchi and YouGov all fall in this zone. 

But it’s not only about individual companies. Mass inflows might finally create a situation in which investors eyeing minnows can successfully fish with a net rather than a spear — that is to say, buy funds instead of trying to pick individual winners.

Brexit means . . . what?

If we work on the assumption that the relative devaluation for UK equities compared to global peers started with the Brexit referendum, it’s important to understand how the impact is being felt.

A Goldman Sachs analysis this year did just that — European strategist Sharon Bell wrote that the effect on large caps has been small (“they’ve performed poorly, but we think Brexit is not the main cause”), but that there had been a “significant hit” for domestic stocks.

Where the damage is coming from is less clear. The call, Goldman says, may be coming from inside the house.

“In our view, any UK discount cannot be attributed to foreign investors’ lack of appetite for UK assets but rather a lack of domestic desire to hold [UK] equity,” Bell wrote.

Goldman is more sceptical than Panmure about the clout pension funds can wield, but sees (or, at least, saw) plenty of potential in the FTSE. “From here, we expect low returns for global equities and in that environment higher regular cash to shareholders may be favoured; two-thirds of UK returns have come from dividends.”

If this thesis proves correct, the UK’s lack of growth momentum may cease to matter as investors will be happy banking the income. We’re sceptical. Long-term investors, Alphaville reckons, should dream bigger.

Still, macro momentum certainly does seem to be with the larger caps: energy prices remain elevated, the push for net zero is going to require lots of mining, and once sterling’s strength fades it will benefit international earners, with their dollar revenues.

All of those tailwinds for internationals are headwinds for domestic stocks. 

Stuck in the middle with you

So, a defensive argument for large-caps and a growth-based one for small- caps. What about the mushy middle?

The price argument is still there — the shares look cheap on Morgan Stanley’s analysis. But where is the momentum going to come from? Honestly, we can’t tell. This is the category that has produced some of the UK’s great recent homegrown stock price successes: think 4imprint, Games Workshop or Greggs. But it is also full of domestically-exposed companies. They are too big to benefit from the pension funds’ promised push into smaller businesses and too inward-looking to gain from any global economic tailwinds.

If you accept the thesis that Brexit is a unique drag on Britain’s domestic economy, then buying broadly into this group is clearly a fool’s errand. Why would you be so hard on yourself? Just concentrate your risk exposure on the US, log out of your brokerage account, play safe and go visit a park or something.

Alternatively, you might think the UK is being dealt with unfairly and investors underestimate British potential. This is reasonable, although last autumn’s market meltdown did little to combat the reputation for economic hara-kiri.

A Barclays note from March looking at UK equities warned investors off the FTSE 250 and domestically-exposed UK stocks, saying “we still lack a strong catalyst to lift domestic growth”. Has anything changed since? No. So stay away. It’s far from “the market can stay irrational longer than you can stay solvent” territory, but it’s no place to make money. It’s Coventry City.

UK companies suffer from rising funding costs

It’s easy to think about investment purely in terms of the investors. But the current UK situation is bad for companies: the more discounted they get, the more expensive it is to raise money, relative to international rivals.

So by not investing into UK stocks, British investors make UK companies worse. They also effectively contribute to keeping those stocks (arguably unfairly) undervalued.

But it’s a dilemma. If, as a nation, Britons decided to pump their savings into UK mid-caps then, in an ideal world, people would make good money, companies would be able to raise more funds, things would improve, and children would play in the street. Coventry City might even win the Premier League.

But as things stand, staking your nest egg on this kind of wholesale turnaround makes no rational sense.

Get some FTSE 100 exposure if it’s your preferred flavour of unexciting defensive investment stodge. If you believe that the government’s strategy can work, find a way to get some exposure to UK small-caps. Leave the middle for someone else. Don’t be a hero.