Why investors should be returning to the UK equity market

Two pros run through several reasons why investors should not be ignoring their home market. 

Why are UK investors so averse to their own domestic market nowadays, and particularly the value-focused areas? 

To put that into some context, since 2015 around £7.3 billion of UK-focused funds have been sold, while investors have bought £58 billion of funds focusing on anywhere else.

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The US equity bubble, increasingly inflated by high-growth stocks, has accounted for much of this redirected investment. Astonishingly, as it reached its peak during 2021, more money went into US equity funds than in the previous 19 years added together.

But that bubble burst in a big way in 2022, leaving the S&P 500 down 18% and the tech-heavy Nasdaq down 33% over the year. 

Over the same timeframe, the UK was one of the handful of global markets that achieved a marginally positive return, with the FTSE 100 index of blue-chip businesses up almost 1%.

Since then, the FTSE 100 has hit a new all-time high, breaching the 8,000 mark for the first time. Largely, says Alex Wright, manager of Fidelity Special Values (LSE:FSV), a member of interactive investor’s Super 60 investment ideas, “that’s been driven by sectors such as energy, mining and banks which have benefited from the macroeconomic backdrop of rising energy prices and higher inflation”. 

Yet despite this market resilience, UK investors sold down almost £870 million of UK equity funds in January 2023 alone - the third largest outflow on record – bringing the number of consecutive months of outflows to 20.

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What’s going on? Ian Lance, co-manager of the UK equity income investment trust Temple Bar (LSE:TMPL), has been arguing for a long time that investors’ relentless focus on the overheated growth-oriented US market at the expense of the UK is a dangerous delusion.

In a recent note, Lance points out that early in 2022 he and his team warned against favouring the US over the UK, basing their conclusions on “the extreme divergence in valuations between the two markets”.

However, the team also noted that that many of the factors that had driven outperformance for the burgeoning US growth market, such as low inflation and declining interest rates, were in the process of reversing. The UK market is less tech- and growth-focused and therefore didn’t feel the pain of the economic rotation to anything like the same extent.

Overseas refocus

Part of the challenge now facing UK equities is rooted in the 20-year shift towards broader overseas equity exposure among UK investors, which has taken place alongside a decline in overall equity allocations. As a consequence, the UK now makes up only around 10-15% of total equity exposure.

Says Lance: “This has created relentless selling pressure on UK equities, which potentially explains why returns have been lacklustre since 2000; even at a new high of 8,000, the FTSE 100 index has only advanced by 15% since its late 1990s high, while the US S&P 500 index is 183% higher.”

Of course, the UK market’s recent resilient performance is at odds with the current economic environment, where the latest GDP figures show the economy avoided a recession but did not grow in the final quarter of 2022.

Nor has investor sentiment been buoyed by a relentless stream of bad news encompassing inflation, rising interest rates, falling real wages, strikes and imminent higher taxes. “Having had three prime ministers and four chancellors in 18 months doesn’t help either,” Lance adds drily.

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His point, however, is that “none of this matters” as far as the outlook for long-term returns is concerned; indeed, it’s the gloomy domestic environment that has left UK equities so extremely and persistently cheap, despite the fact that 70% of blue-chip earnings are generated internationally anyway. Better still, the average dividend yield for the UK market is among the highest in the world.

Lance also speculates that the market’s relative lack of tech and growth companies, and bias to value-oriented energy and mining stocks, may work as a tailwind rather than a headwind in coming years.

Alex Wright takes the argument in favour of UK equities in a slightly different direction, pointing out that even within the market spectrum there is “huge discrepancy” in returns between strong large-caps and the rest.

“In fact, 2022 saw only a very small proportion of the FTSE 350 constituents (around 20%) outperform the index - the lowest number on record since 1990, according to research by Berenberg,” he comments.

In other words, a handful of energy, mining and other blue-chips were driving overall index performance, leaving huge opportunities still to tap into mid-caps and smaller companies where in some cases “share price declines have been excessive” over the past year.

“Despite an uncertain economic outlook, the large divergence in performance between different parts of the market create good investment opportunities, with attractive upside potential on a three- to five-year view,” he says. His portfolios are currently weighted around 60% to mid and small-caps.