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Andy Raikes

Globe WorldWatch

UK equities: embracing the opportunity

WorldWatch
17 July 2024

By

Co-Portfolio Manager, TT Environmental Solutions Strategy; Portfolio Manager, TT UK Equity Strategy

There has been much discussion recently about ways to increase investment into the UK equity market, with both the former and current governments keen to encourage pension funds to allocate more capital domestically, while the FCA seeks to enhance the London Stock Exchange’s appeal for new listings. Having managed UK equity portfolios for over 25 years, recently celebrating two decades of running the TT UK Equity strategy, I wanted to offer some perspectives on the current landscape, what is changing, and why I believe pension funds should be seizing the compelling opportunity that UK equities offer today.

The current landscape

UK pension funds have been decreasing allocations to UK equities for a long time. Between 2002-2022, total equity allocations in UK Defined Benefit schemes fell from 64% to 15%, with the proportion invested in UK equities falling from 39% to just 2% (Source: Investment Association). This was partly driven by a trend to de-risk portfolios through global diversification. However, UK outflows materially accelerated following the Brexit referendum, as investors shunned the UK amid increased uncertainty and risk.

What is changing?

There is clear intent among UK public bodies to reverse this trend. The previous government stipulated in the Spring Budget that LGPS funds will be required to publicly disclose their UK equity investments, with the government potentially taking “further action” if allocations don’t increase. Whilst detail is scant at this stage, comments from Rachel Reeves suggest that Labour’s pension agenda will continue in a similar vein. Indeed, she has spoken of going further, saying it is “a missed opportunity” that the Mansion House Compact did not stipulate investments in the UK economy and that Labour will review the entire pensions industry, including the LGPS, to attract greater investment into the UK economy.

Meanwhile, London Stock Exchange listing rules look set to see a significant shake-up in an attempt to make London more attractive for company listings. This combined approach to encourage more investment into the UK economy and its stock market suggests that the government is serious and that change is coming. However, these potential changes divide opinion, with some pension managers reticent to increase allocations to a UK market that has underperformed its peers for many years. 

Is this reticence misplaced?

I believe that now is an opportune time for asset allocators to be increasing UK equity weightings. UK equites have underperformed global equities for a number of years, most markedly since the Brexit referendum in 2016. Much of that underperformance has come from a material devaluation, as persistent outflows accelerated following Brexit, weighing on share prices and valuations. Indeed, on a sector-neutral basis, which adjusts for differences in sector exposures, the UK market has derated from a small Price-to-Earnings premium to global equities in 2016 to a c.20% discount now, the largest discount in 30 years.

UK sector-adjusted price-to-earnings ratio relative to world

UK PE rel to ROW

Source: Key conclusion July 2024 © UBS. All rights reserved. Reproduced with permission. May not be forwarded or otherwise distributed.

This valuation discrepancy is also evident when looking at market-implied discount rates, with the implied cost of capital in the UK having diverged significantly from other major markets in recent years, leaving it as a clear outlier, implying material undervaluation. 

Market-implied real cost of capital

market-implied real cost of capital

Source: Canaccord Genuity Quest

Furthermore, this undervaluation becomes even more extreme in UK mid- and small-caps, which are trading at historically wide discounts to the broader UK market, itself already cheap versus global equities.

Of course, valuation alone is rarely a sufficient reason to warrant investment; one needs to identify catalysts to reverse the undervaluation. But here too there are grounds for optimism. Firstly, even without a ‘stick’ from the government, there are signs that outflows are abating and potentially reversing as allocators increasingly recognise the compelling investment opportunities available in the UK market. This trend would clearly accelerate materially if domestic pension funds were required to increase allocations. Another important catalyst is the improving economic backdrop. The economic situation has been challenging, but there are signs that momentum is improving. We are past the worst of the cost-of-living crisis, with real wage growth accelerating and interest rates set to fall. This is evident in improving macro indicators such as consumer confidence, manufacturing PMIs and the OECD Composite Lead Indicator. An improving economic outlook is positive for the broader UK market, but particularly so for mid- and small-caps, which are more geared to the domestic economy, and therefore tend to perform better versus large-caps when UK economic prospects brighten.

I also believe that the recent election result provides a backdrop of much-needed political stability in the UK. This should give long-term pension investors greater confidence to allocate more to the UK and take advantage of the opportunity currently available.

Given all these factors, I am optimistic on the outlook for UK equities, and particularly for mid-caps. Accordingly, I have significantly increased mid-cap exposure in the TT UK strategy, where the investment opportunity is as compelling as any I have encountered in my many years managing UK equity portfolios.


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