The latest Calastone data showed another grim month for UK-focused funds in January. They shed a further £1.07bn, the sixth worst month on record. It seems even record UK share prices, buoyant M&A activity and bargain-basement prices cannot lure investors back. But has this relentless selling pressure started to look increasingly out of step with reality?
The arguments against the UK market are familiar. First and foremost is its sluggish economy. The latest UK GDP growth figures suggest the situation is not relentlessly grim, with the UK economy growing by 0.1% in the final quarter of the year, ahead of expectations. Nevertheless, any self-sustaining momentum for the UK appears elusive.
There are risks to even this lacklustre growth. Early estimates suggest Trump tariffs, if implemented as planned, could cost the UK as much as £24bn, according to the National Institute of Economic and Social Research.
Inflationary pressures remain and even if UK inflation does not materialise, it could be the UK is caught up in the contagion from higher US inflation. When 10-year gilt yields spiked to 4.9% in early January, the culprit was, for the most part, higher bond yields in the US.
Professor Anand Menon, director, UK in a Changing Europe, said: “Debt interest repayments are high, which is already difficult to manage at a time when there are low levels of growth. One of the things that differentiates us from many other European countries is that we are uniquely exposed to international interest rates when it comes to our debt repayments.”
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He added if the UK is forced into higher defence spending from Washington it could dent the fragile equilibrium in the government’s spending plans. He said: “If Trump says ‘I’ll let you off tariffs if you make defence spending 3% of GDP,’ that puts the chancellor in a really difficult situation.”
There were reports this week that Prime Minister Keir Starmer plans to over-rule the chancellor on limits to defence spending.
Nevertheless, while the picture is difficult for the UK economy, the economy is not the stockmarket. There are tentative signs of international confidence returning to UK financial markets. For example, recent analysis by the Financial Times found that sterling volatility has been lower under Starmer than at any point in the past 35 years. The pound rose to its highest level versus the dollar in two months this week.
Equally, the enthusiasm of international trade and private equity buyers for UK assets suggests they do not share investors’ squeamishness on the UK. M&A activity has continued at pace, with bids for DS Smith, Britvic and International Distribution Systems. Companies have continued to buy their own shares. This is now a phenomenon across the market-cap spectrum.
The FTSE 100 has been hitting new highs in recent weeks, having risen almost 6% for the year-to-date. There is a sign the UK may be a beneficiary of a diversification in global market leadership. The market capitalisation of the UK market is smaller than that of Apple or Nvidia. If $600bn comes out of Nvidia in a single day – as it did on news of DeepSeek’s launch – it could buy BP eight times over.
However, any nascent strength in the UK market has not yet found its way into smaller and mid-cap stocks. The FTSE Small Cap continues to languish after its promising start to 2024 stalled in the second half of the year. The FTSE Small Cap is flat for the year-to-date. The FTSE 250 is up 1.4%, but still lags the large caps.
For Simon Murphy, manager on the VT Tyndall Unconstrained UK Income fund, it is the most compelling opportunity set he has seen in his 25-year career.
“Currently, we see a huge array of investment opportunities at valuations we have rarely seen before,” he said. He admitted that sentiment is on its knees and some of that is justified, but added: “I would defend the outlook for the domestic economy. It is better than most people fear.”
He is backing this with exposure to domestically-focused companies such as Wickes and Dunelm. His fund currently holds 24% in consumer discretionary companies: “Interest rates continue to gradually fall, consumers are in reasonable shape and government fiscal support is significant and, in many cases, increasing,” he said.
He added there are tentative signs that the government recognises some of the problems with the UK stockmarket. It is looking at ways to encourage pension funds to invest more in domestic equities by shifting their risk parameters. “This will take time to come to fruition, but it is a statement of intent and it only has to improve the flow a little to change the dynamic for the UK market.”
Murphy’s view is the picture on the ground for UK companies is considerably better than the weak sentiment would suggest.
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Abby Glennie, deputy head of smaller companies at abrdn, echoes this analysis. While more cautious, she said the companies she talks to say the environment is ‘ok’. Also, she added, expectations are so low because of the weak sentiment towards UK equities that companies are not finding it difficult to beat them.
However, she added more rate cuts would help. There are signs that the Bank of England is shifting its position. In a speech at Leeds Beckett University this week, Catherine Mann, monetary policy committee member, said monetary policy needed to “cut through the noise”.
Previously seen as the most hawkish member of the MPC, she voted for a 0.5% cut at the latest meeting and said previous rate rises had not done enough to loosen financial conditions. She said weakness in the economy had weakened inflationary pressures and constrained the ability of firms to pass through costs as higher prices.
The week ahead is an important one for the UK, with CPI, retail sales and PMI data. It will give greater insight into whether the UK has an inflation problem or not, and therefore whether more rate cuts are likely. If the news is positive, it may show that, increasingly, the gloom may be misplaced.
