UK Equities
David Finn
UK Multi Asset Portfolio Manager
What makes a market?
Given all the negative headlines, investors may not have expected to see UK equities outperform global equities last year, returning 1.2% (in EUR terms) compared to global equities which fell -12.6% (in EUR terms). In fact, performance was so strong, the UK equity market performance was ahead of all major markets in 2022.
Bucking the trend
After underperforming global equities in fourteen of the last twenty years (including the last ten years in a row), this sudden change of fortunes may have come as a surprise, especially given the political turmoil experienced in 2022. The last year has seen three changes of prime minister and four different chancellors; not to mention the LDI (liability driven investment) crisis which shook bond markets, brought on by the government’s calamitous mini-budget in September. Not exactly the political backdrop one would expect for an outperforming stock market.
The last year has seen three changes of prime minister and four different chancellors; not to mention the LDI (liability driven investment) crisis which shook bond markets
Figure 1: Global equity performance vs UK equity performance (annual, 2003-2022)
Source: Bloomberg, performance based in EUR terms using total return indices
Naturally, the poor recent run of UK equities has resulted in considerable underperformance over longer time periods, despite the recent turnaround. The resurgence has us asking two questions:
Why did things turn around for UK equities after such a long period of underperformance, and is it likely to continue?
Figure 2: Global equity performance versus UK equity performance (rolling returns, 2003-2022)
Source: Bloomberg, performance based in EUR terms using total returns indices
Think sectors, not regions
Taking the first question on the lengthy underperformance of UK equities, it’s important to remember the stock market is not the economy. While economic growth in the UK was positive, this has very little bearing on the performance of the stock market. The reason being, the UK stock market is mostly made up of large, global companies which generate revenues and profits all over the world. In fact, around 75% of the UK market’s revenues come from abroad, meaning the fortunes of companies like HSBC and Unilever rely on more than domestic growth. While there are companies heavily dependent on the UK economy, they are typically smaller and therefore have much less impact on the index performance as a whole.
That being said, other major stock markets are also dominated by large, global companies, so it doesn’t explain the strong performance of the UK market. When discussing the lack of innovative and fast-growing companies listed in the UK, former Baillie Gifford fund manager James Anderson recently described UK equities as a “19th century and not even a 20th century index." However, the change in the market environment has meant this has now become a positive. The lack of exposure to high-growth sectors in UK equities meant it avoided the significant drop in technology stocks, and a corresponding increase to sectors like financials and energy, means the index benefitted from an environment of rising rates and increasing commodities prices.
Figure 3: Sector weights* - UK versus global equities
Source: Bloomberg; *Sector weights as of 31st March 2023
We know from history that sectors will perform differently under different market conditions. This leads us to our second question: Is the current outperformance of UK equities likely to continue?
The UK market is shrinking
UK equities have become a much smaller share of global markets overall in recent years, and it’s important for investors to consider that the UK is no longer a true reflection of the global economy. One of the reasons for this shrinking market share is the growing number of UK companies moving their stock market listing overseas, in particular to the US. The world’s largest building materials company, CRH, is the latest corporation seeking to leave the UK index. This comes after Softbank announced their intention to list their Cambridge-based subsidiary arm in the US, while gambling company Flutter plans to establish a secondary listing in the US also.
Why is this pattern emerging? Company executives see the US as an environment that embraces higher growth and is drawn by a larger, more liquid market that places higher valuations on similar companies. One reason for the lack of depth in the UK market is that pension funds, traditionally some of the largest investors in UK stocks, have reduced their exposure to UK companies considerably over the past twenty years. Recent data indicates that UK holdings in British pension and insurance funds have fallen from about half to around 4%.
This significant shift in asset allocation was driven partly by accounting changes brought in at the turn of the century, which meant that companies would have to recognise pension fund deficits on their own balance sheets. This led to the development of the now infamous LDI strategies, which promised to match portfolios more closely to fund obligations. In simple terms, this meant selling equities to buy long-dated government bonds.
Where to from here?
Technology is a catch-all term for new innovative companies with industry-changing products, which encompasses a wide range of sub-sectors; increasing exposure to this sector may increase portfolio exposure to a more diversified range of return drivers. Furthermore, if the trend of investor preferences continues toward sustainability, demand for large energy companies that dominate the UK market may fall, further depressing valuations. So, while UK equities are currently experiencing a resurgence, it may prove difficult to sustain into the future.
If the trend of investor preferences continues toward sustainability, demand for large energy companies that dominate the UK market may fall, further depressing valuations.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.