The case for the UK
The UK has been a relatively unloved market for some years, however recent performance has reignited interest. Portfolio manager, Alex Wright, examines the reasons to be positive about the UK’s prospects moving forward.
The UK has been relatively unloved by investors in recent years, with many deciding to look at opportunities in the US or Europe instead. With events such as the UK mini budget at the end of 2022 bringing about financial turmoil, investors have felt that this has been indicative of the instability of UK markets in recent years. However, 2022 saw UK equities outperform both US and European markets. Does this mean that there may be opportunities to be found in UK markets?
A positive shift
In recent years we have seen a de-rating of UK-based equities due to top-down concerns around Brexit, economic uncertainty and mixed messaging from policymakers. In a global context, we believe that this de-rating makes UK equities undervalued compared to other developed markets, especially when compared to stocks in the US.
Investment in the UK is compelling when you compare current UK valuations to historic valuations. Prior to 2015, UK markets traded slightly higher than the Eurozone and only at about a 10% discount to the US. In the 5 years after that point, the valuation gap expanded with UK stocks closer to a 45 or 50% discount compared to the US. With the UK generally trading on 10.5x forward earnings currently, it is well below its 10-year average, providing a compelling case for UK equities moving forward.
This valuation narrative began to bear fruit in 2022 as we saw a more resilient performance from UK equities than European and US markets. 2022 also saw value stocks outperform and provided UK equity strategies with a broader tailwind due to the UK’s tendency towards a value bias. The start of 2023 has continued this positive trend and could signal more opportunity to come.
Banks provide opportunity
The UK has a long history within the bank and financials sector, though it has fallen out of favour in recent years. We hold large positions in banks across the spectrum for a variety of reasons. While controversial at the moment due to recent events with Credit Suisse and US-based banks, financials provide both quality and value opportunities as the sector has evolved greatly over the past 10 years.
The industry faced a plethora of headwinds following the financial crisis, with falling rates squeezing margins on deposits and increased regulations meaning shareholders faced a reduced share of profit due to fines and stronger balance sheet requirements. Now, however, we have begun to see those headwinds convert into tailwinds as tighter regulations ensured better balance sheets and strong funding. This has converted into higher levels of buybacks and greater profit sharing now that fines have been paid off. In addition, the low interest rates that followed the financial crisis have started to rise, meaning greater margins on deposits can be achieved and an additional revenue stream is re-emerging for UK banks. These deposits have a tendency to be “stickier” than those in US banks, so present a lower risk revenue stream and banks such as top-ten holding NatWest are well placed to benefit from this higher rate environment. This stickiness and broader, low-value deposit base can also help insulate UK banks from the problems hitting those in the US.
In addition to positive sentiment around banks, we believe that there are reasons to be positive about life insurance. We view the life insurance sector as being very defensive and it has demonstrated its resilience through different cycles over the past decade. When the Covid pandemic forced the world into lockdowns, many businesses saw their earnings negatively affected, but earnings of those in the life insurance sector, such as Legal & General, Phoenix and Aviva, did not fall. In addition, attractive valuations, high dividend yields and compelling earnings supported by annuity products providing longer term cash generation give encouragement for longer term returns from this sector.
Consolidation can bring upside
While there are longer term value opportunities to be found, these lower valuations also provide the prospect of mergers and acquisitions. UK M&A activity has been unprecedented in recent years, driven primarily by private equity and US-based corporates who are willing to pay prices based on US valuations. Special Values has been able to take advantage of this interest in 2022 with M&A activity having taken place across the market cap spectrum. While rising rates have dulled the ability of private equity groups to borrow, we expect to continue to see bids from corporates and we see potential for our holdings to continue to benefit. In the first few months of 2023, already three of our holdings have been bid for.
The outlook looks bright
The relative attractiveness of UK valuations versus other markets and the large divergence in performance between different parts of the market continue to create good opportunities for attractive returns from UK stocks on a three-to-five-year view. In our opinion, the UK market with its higher dividends offers a better prospective return than many other asset classes, including global equities.
Important information
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments are subject to currency fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. The trust invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. This trust uses financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference in this article to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
The latest annual reports, key information document (KID) and factsheets can be obtained from our website at www.fidelity.co.uk/its or by calling 0800 41 41 10. The full prospectus may also be obtained from Fidelity. The Alternative Investment Fund Manager (AIFM) of Fidelity Investment Trusts is FIL Investment Services (UK) Limited. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited.
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