Is now the right time to invest in the UK?

For the UK economy, 2022 was a year to forget, as energy prices rocketed, growth slowed, inflation soared to double-digit levels and the Bank of England imposed a series of interest rate rises to try and regain control of it. Unsurprisingly, markets saw a great deal of volatility and investor confidence took a nosedive.

But nuggets of cheering news have come through more recently: November’s GDP numbers were better than expected, and there are hopes that rates may not have to rise to 6% as anticipated following the mini-Budget last autumn.

Moreover, the UK’s blue-chip FTSE 100 index ended the year more or less flat. Further gains since then, peaking at 7866, leave it close to breaching its May 2018 record of 7903. 

Questions arising for putative UK investors include how much more economic gloom may be in the pipeline, how that could impact company earnings – and how far further bad news has already been priced into share valuations.

The consensus is that the macro gloom will persist into 2023. Says Stuart Widdowson, manager of Odyssean Investment Trust: “We’re expecting softer economic growth, potentially with a recession; inflation continuing above trend but decreasing; rising interest rates; and tighter debt markets for companies that have borrowings. There is anticipation that many companies will reduce earnings guidance for 2023.”

Guy Anderson of Mercantile Investment Trust makes the further point that the UK labour market remains tight, with widespread shortages amplified by ongoing industrial action, while rising interest rates are hitting the housing market. “The trajectory of wages, employment and house prices will influence consumer cash flows and confidence, and hence the earnings of domestically focused companies,” he warns.

However, companies are in a relatively robust condition to face a slowdown. As James Henderson of Henderson Opportunities Trust, observes, they “have spent several years battling with a difficult market environment caused first by Brexit and later by the pandemic. As such, they are far more prepared for the challenges ahead – they already have disciplines and procedures in place.”

The bottom line is that the UK market looks historically cheap. “Valuation on equities is relatively low at around 10 times [earnings], and portfolio yield is between 4.5% and 5%,” adds Henderson. “Historically, these are attractive figures, as long as you believe that there is some robustness in that earnings number.”

Anderson agrees that there’s reason to be optimistic despite the macro uncertainty. But he emphasises the need to identify resilient businesses with pricing power and strong balance sheets.

That really isn’t too difficult in the current environment, says Nick Train, manager of Finsbury Growth & Income. “Work on the assumption that the worse it feels, the better the value. The All-Share is up barely 30% since the start of 2000, yet it contains many substantive, world-class businesses. You really don’t have to look very far to find bargains.”

Importantly, different parts of the UK market have been differently impacted. While the blue-chip index, fortified by energy, mining and financial stocks, had a resilient 2022 and continues to strengthen, the domestically oriented mid and small cap sectors have been much harder hit.

In fact, says Alex Wright, manager of Fidelity Special Values, “2022 saw only around 20% of the FTSE 350 constituents outperform the index – the lowest number on record since 1990, according to research by Berenberg.”

He believes that valuation levels and the large divergence in performance between different parts of the UK market could equate to attractive returns for canny stock pickers over the next three to five years.

So where, specifically, are UK managers looking for rewards over the coming years?

Widdowson’s focus is specifically on the mid and small-cap universe, where stocks are still trading below the long-term averages, though they have improved since the autumn nadir. He likes ‘special situations’ stocks where management or other action can provide an extra performance kick as wider recovery occurs.

Conversely, he warns, high-growth stocks remain relatively expensive. “With the investment community digesting that there is real cost to borrowing money, it is unlikely that there will be a swift re-rating of growth,” he adds.

As a value investor, Wright favours banks, which have the current tailwind of rising interest rates boosting profits; he is steering clear of businesses likely to be directly or indirectly impacted by the increased cost of borrowing, such as housebuilders.

At Mercantile, Anderson is on the lookout for the strong businesses that continue to win market share, but that have been de-rated in the wider market fallout. He cites UK retailer Dunelm: “It is likely to face challenges in the near term from consumer weakness, but should emerge even stronger from this difficult period.”

Henderson takes a similar tack, “looking for companies with a genuine excellence in their product or service offering that will help distinguish them from their peers in the months ahead.”

He too is interested in proactive retailers, for instance M&S, and also in UK manufacturers. “In recent years, the sector hasn't seen a capital spending boom so there isn't the spare capacity you might expect to usually see. This, coupled with the depreciation of sterling, has positioned it competitively in the UK,” he explains.

Clearly, this is a time where selectivity is crucial in the UK market. But the combination of robust, high-quality businesses and low valuations is an increasingly attractive one in the eyes of professional stock pickers.