UK equities are pricing in a much more pessimistic economic outlook than we believe is likely, and there are opportunities to be found in domestically focused businesses and multinationals.
The UK’s outlook has seldom appeared gloomier. On the economic front, taxes are at their highest level since the Second World War, Brexit has cast doubt on the country’s relations with Europe, and the UK appears to have sunk into a trough of low growth and relatively high inflation. The economy flatlined in the three months to the end of September, for example, and the Bank of England anticipates zero growth in 2024 too.1
Inflation stood at 6.7% in September, an annual pace that remained unchanged from the previous month, but fell to 4.6% in October. While this feels like an abrupt fall, by comparison, inflation has already reached 3.2% in the US and 2.9% in the eurozone in October.2 Goods inflation remains stickier in the UK, and this has spooked the market. Investors assume it means the Bank of England will maintain its interest-rate stance, which is weighing on sentiment and equity valuations.
Politically, too, the country is experiencing unprecedented instability following Brexit, with four prime ministers in the past four years. The ruling Conservative Party, in power for the past 13 years, is trailing badly in the polls and the left-of-centre Labour Party appears likely to win the next general election, which is due by 28 January 2025 at the latest.
The darkest hour is just before the dawn?
Yet there are sound reasons to believe the UK’s economic prospects are better than they appear. Inflation is likely to fall much faster than the market anticipates, according to our analysis. Ebbing import costs – helped by falling prices in China, a major trade partner – are pointing to a softening in goods inflation. Signs that the labour market is cooling should also alleviate sticky inflation in the services sector. Consequently, we foresee consumer price inflation can continue to ease to closer to 3–4% by the end of the year. Such an outcome would allow the Bank of England to ease its monetary stance, which in turn should encourage the market to become more positive about economic prospects.
Encouragingly, too, business and consumer confidence remain resilient. For example, the latest quarterly UK Business Outlook from Accenture and S&P Global, published in October, reports that UK businesses are relatively optimistic compared with international rivals.3 Broadly speaking, households are well placed despite a tripling of mortgage rates, supported by built-up savings balances and a manageable level of mortgage obligations. Mortgage rates are typically fixed for 3–5 years, so the impact of the increase from 2% to 6% has been gradual. To date, the impact of rate rises on households equates to a fall in disposable income of just 2%. A lack of housing supply is also supportive of house prices. All this suggests the UK banking system should stay resilient and the financial sector stable.
At the same time, UK equities are cheap both historically and in relation to other global markets. They’re priced at a 20% discount to their own history, at around 11x forward earnings. Indeed, the multiple has only been lower on three occasions during the past three decades: during the 2008 financial crisis, September 11, and following the outbreak of COVID-19. Notably, the UK’s discount to the rest of the world is relatively persistent across different sectors.
Current equity valuations imply the market is pricing in a hard economic landing. However, we believe the UK’s economic fundamentals don’t support such an outlook, and that investors can find enticing opportunities in the UK including the UK-listed multinational Diageo, a world-class spirits business with leading brands, which is now priced at attractive levels.
Read our Q3 Market Update to discover how you can access the opportunities to be found among UK equities.
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