Political uncertainty to further hit fund investor demand

Fund managers give their take on the leadership race, which in the short term at least could negatively impact investor sentiment towards UK funds. 

Despite the cheaper valuations on offer versus other exchanges, and standout performance in the first half of 2022 from some of its larger company constituents, the UK market continues to be given the cold shoulder by investors.

As reported last week, the latest statistics from the Investment Association show that investors dumped £1.2 billion from UK funds in May. This is far from being a new trend – UK equity funds have been out of favour since the Brexit vote in June 2016. Since then, the three UK fund sectors (UK all companies, UK equity income and UK smaller companies) have in the vast majority of months seen more money withdrawn than invested.

Uncertainty stemming from Brexit and the Covid-19 pandemic have been the two big headwinds deterring investors.

Heading into 2022, there was optimism from fund managers that investor sentiment would improve towards the UK – given that both those headwinds had somewhat receded. The end of January marked two years on from the UK’s departure from the European Union, while the successful vaccine rollout has allowed the economy and society to reopen.

• Investors ignore strong returns and dump British stocks for US rivals
• Investors are turning to income funds, but is a trick being missed?
• Global dividends hit new record, but outlook uncertain for 2023

However, following prime minister Boris Johnson’s resignation last week, there is a new headwind – political uncertainty. This is likely to further discourage investors from their home market, in the short-term at least.

This is acknowledged by Laura Foll, co-manager of Lowland (LSE:LWI) and Law Debenture Corporation (LSE:LWDB).

She said: “Political uncertainty comes at a time when sentiment towards UK equities is already poor – this can be seen reflected in lower UK company valuations in many cases than overseas peers as well as recent weak net flows data for UK equities."

However, as Foll points out, when a new leader is appointed, this could turn from a headwind into a tailwind, resulting in investors returning to the UK market.

Foll added: “The events of last week, while unlikely to mean this overhang on UK equities is resolved in the very short term, could mean that once a new leader is established that the perceived additional political risk associated with UK equities is, to a degree, lifted. It therefore ‘brings to a head’ political uncertainty that has formed part of the overhang on UK equities.”

However, as Azad Zangana, senior European economist at Schroders, points out, uncertainty over the direction of the UK economy is likely until a new leader is appointed. 

At the time of writing there are 11 runners and riders to be Britain’s next prime minister, with different visions on how they would put their stamp on the top post. The contest will be concluded by 5 September.

He notes: ““Looking ahead, the outlook hinges on who Johnson’s replacement will be. A return to traditional Conservative politics will probably bring about some austerity over the next few years, but also a return to business friendly policies. However, another populist politician could lead to more of the same approach for the economy.”

The multi-asset team at Invesco, the fund manager, is bearish on the UK economy. The team points out that even after a decision on the new leader has been made “the approval of a much-needed fiscal package to help the UK consumer is not guaranteed.”

The team add: “Unfortunately, the UK economy will continue to wither in the interim as a result. Out of the major developed economies, it’s here that we see the highest risk of a recession. Sterling weakness has been the way to play this view.

“We think the UK consumer will see the greatest real income squeeze. National insurance contributions have risen, and Brexit related idiosyncratic developments have added more fuel to the inflation fire pushing food and energy bills substantially higher. The UK is enduring some of the highest inflation rates of any industrialised country.”

However, it is worth bearing in mind that the UK economy and UK stock market are not the same thing. In the case of the FTSE 100, the majority of earnings are derived from overseas. This and strong performance from oil companies has helped cushion losses against the stormy market backdrop so far in 2022, with the FTSE 100 down 3.6% year-to-date.

• The best and worst funds so far in 2022
• Why world’s biggest fund manager isn’t buying the dip
• Time to turn to alternatives as bear market bites

In contrast, UK mid- and small-cap indices, which house stocks that tend to generate most of their profits in the UK, have fared badly. The FTSE 250 is down 20%, while the FTSE SmallCap index has given up 16.8%.

The same pattern plays out in terms of fund performance. Data from FE Fundinfo shows the UK Smaller Companies sector is down 24.1% year-to-date. This compares to a loss of 11.9% for UK All Companies, and a small loss of 5.5% for UK Equity Income.

Prior to Johnson’s resignation last week, the continued apathy towards the UK market had been leaving various fund managers perplexed. Nick Train, for example, manager of Finsbury Growth & Income (LSE:FGT) investment trust, told interactive investor’s head of markets Richard Hunter in an interview earlier this year that “the UK market has been unfairly neglected in recent years”, despite UK companies being “undervalued relative to their global peers”.

Simon Brazier, fund manager of Ninety One UK Alpha, a member of interactive investor’s Super 60 list, recently told our Insider Interview video series that Brexit uncertainty is still holding back investors.

He said: “I speak to many investors across the world and some of them are still worried about Brexit because we still haven’t seen the full outcome play out. For example, we are still not imposing checks on goods coming into the UK from Europe, and that’s something that’s [been] thrown at me by some of my investors worrying [about] what will the outcome of that be.”

Brazier points out that it is human nature to “buy when things go up rather than when they’re going down”. As a result, he hopes the recent outperformance that the UK stock market has enjoyed versus overseas exchanges will continue and prove to be the catalyst for investors to increase exposure.

• Why I own Lloyds Bank shares and have been buying HSBC
• The UK consumer shares I am backing to win

For Paul Marriage, who manages TM Tellworth UK Smaller Companies, the turning point will be when investors get past “peak grumpiness”. He notes that while there could be further short-term pain, a lot of bad news has been priced into valuations.

In a recent video interview, as part of our Insider Interview series, Marriage added that it is not a surprise that UK smaller companies have been out of favour. He said: “When markets are scared about things like a war in Europe or macroeconomic issues, UK small-cap is the sort of asset you run away from, really. It's not something you buy on first missile, unfortunately, and it's not something you really buy when you're worried about the domestic economy.”

• How I find small-cap gems, and three favourite shares
• An AIM share tip and two stocks we've just bought