We believe UK equities are back on the menu. Having been banished to the wilderness on the back of a higher inflation environment, Brexit fallout, economic pessimism and sluggish growth forecasts marring UK plc, value-hungry corporates are turning their attention to the UK market. Depressed valuations across the market-cap spectrum have prompted a surge in M&A in the UK, with $77bn¹ of deals announced so far this year, compared with just $25bn for the whole of 2023. With bolt-on deals across the market, companies accelerating investment plans and raising capital to invest, we believe the UK market has got its mojo back.

Why has sentiment turned a corner?

From a top-down point of view, we think this renewed enthusiasm for UK equities can be largely explained by the resolution of three important issues.

First, while the UK’s inflation rate peaked above levels seen in the US and mainland Europe, the UK consumer price index (CPI) hit 2.3% in the year to April 2024 – it was 8.3% a year ago. This compares to 3.4% for the US and 2.4% for the eurozone. It is no longer an outlier concerning inflation and currently sits below the 2.4% level of both France and Germany, with a near-term step down to 2% a strong likelihood, in our view.

UK GDP grew 0.6% in the first three months of 2024, faster than the eurozone’s 0.3% and the US’s 0.4%. This puts the UK back in growth mode and means the country is performing better than most other developed peers.

Second, while the UK experienced a mild recession in the second half of 2023, with GDP falling by 0.3% in the final three months of 2023, GDP grew 0.6% in the first three months of 2024, faster than the eurozone’s 0.3% and the US’s 0.4%. This puts the UK back in growth mode and means the country is performing better than most other developed peers.

Third, despite the general election garnering media attention, we would argue the political backdrop was already much calmer in the UK and we have seen a muted reaction in the currency, bond and equity markets since the election announcement. While there is always a degree of uncertainty around elections, the polls continue to show a pretty conclusive position, favouring Labour’s broadly centrist policies. As we saw around Brexit, the foreign exchange market is a brutal arbiter of the situation and sterling has actually risen since the election was called. All this serves to highlight our belief that, politically, the UK looks much better placed than many other developed markets around the world.

UK valuations still lag compelling tailwinds

Despite the emergence of what we feel are meaningful catalysts for UK indices, valuations have failed to take notice. As such, in our view the UK market now looks highly appealing on all valuation measures compared to global equities. If we look at price-to-earnings (P/E), EV/EBITDA, price-to-book (P/B) or dividend yield, the UK appears to offer good value, as we see it, particularly among the country’s mid-cap companies.

It is always worth remembering what a good place to hunt for ideas the FTSE 250 is. Since its inception, the Index has delivered 10% compound annual returns and earnings growth. While we invest across the market-cap spectrum, we currently have 46% of the Fund exposed to the FTSE 250, with nearly 70% of the Fund in small and mid-caps (SMID-caps). That is very different to many other UK funds that mirror more closely the market-cap allocation of the benchmark.

Broadly, the FTSE 250 looks particularly attractive to us, in valuation terms, and we believe it is well placed to recover some of its recent underperformance relative to the FTSE 100 as interest rates fall. While the market has shown a particularly cold shoulder to the nation’s SMID-caps, should an improved inflation and interest rate environment create a positive catalyst into H2 2024, a low starting base for SMID-cap valuations could be complemented by a supportive outlook regarding underlying business performance. We are seeing evidence of companies experiencing better trading conditions and management teams putting cash to work efficiently, making well-priced bolt-on acquisitions and upping capital expenditure capex). This could suggest overlooked companies outside the top flight have the greatest opportunity to lift their valuations among all UK companies.

Will 2024 close the UK valuation gap?

After a long and difficult period for UK equities, they are catching investors’ attention once again. To us, the volume of M&A interest at a corporate level signals a growing realisation of the disconnect between an improving macroeconomic backdrop, companies displaying solid fundamentals and a clear valuation discount. Indeed, we have benefitted from four bid approaches for portfolio holdings in the Fund this year as a result. With inflation in a far better place, GDP upgrades and a stable political backdrop, we feel this is a good environment for valuations to rerate.

We continue to focus our efforts on buying good businesses, who are improving their returns on capital, with strong balance sheets and good cash generation and discounts to their intrinsic value. We believe the current environment is giving us access to world-class businesses, delivering consistent returns at cheap valuations.

1. Deutsche Numis, 1 Jan ’24 to 23 May ’24.