The UK equity market: Where do we go from here?

Strategist Paul Danis and Thomas McGarrity from the equity research team discuss the UK stock market, its characteristics, how it differs from the U.S., and the UK companies that could catch investors’ eyes.

The first half of 2024 has been an eventful one for the UK equity market, with the FTSE 100 benchmark index of UK company shares reaching an all-time high, having lagged its American cousins quite significantly over the previous year.

The UK chancellor also announced the launch of a UK-only ISA, but that may never come to pass now that a general election has been called.

With the U.S. having generally outperformed the UK equity market over the past few years, some investors are throwing in the towel on UK stocks and our clients have fewer than they had in previous years. So, what are the prospects for UK stocks?

Understanding the UK equity market and its international exposure

The first thing to note about the UK equity market is that it’s not a pure reflection of the UK economy.  In fact, it’s very internationally exposed, with an estimated three quarters of the revenue of FTSE 100 constituents coming from outside the UK. The UK equity market therefore tends to be driven more by international rather than UK specific economic developments. The performance of the U.S. or Chinese economies will often be as important for the UK equity market as domestic UK economic activity.

There are different types of companies listed on the UK market. It has a high representation of commodity-orientated sectors such as miners and energy companies, as well as sectors that are not so sensitive to the economy, like healthcare, food, tobacco and beverage makers. It also has a relatively high proportion of financial companies. However, what it lacks is a lot of exposure to technology companies and those powering the artificial intelligence (AI) revolution. For that we tend to prefer the U.S. stock market.

The July election and the domestic economic outlook

While the domestic economic outlook is less important, it still matters. Indeed, there has been a reasonably close relationship between the performance of UK versus global GDP, and UK versus global equity performance.

The obvious catalyst for change would be next month’s general election, which Labour seems set to win with a strong majority. Against that backdrop, we can speculate on what a Labour government might mean for UK economic growth prospects.

Shadow Chancellor Rachel Reeves is projecting a tough image in terms of balancing the books, so we shouldn’t expect reckless government spending. Even if Labour wanted to fund its spending via borrowing, the current fiscal reality will likely make it wary of doing so outside of a crisis. With this in mind, Labour’s ability to boost UK economic growth is likely to rest on the impact of several of its policies that don’t require much spending. Let’s look at four of these policies.

Labour wants a better relationship with the EU. This could support UK growth through trade, which has suffered relative to its G7 counterparts since Brexit. However, a report from the UK Trade Policy Observatory flags that three years since the implementation of the Trade and Cooperation Agreement in 2021 between the UK and the EU, the UK-EU trade (as a share of total UK trade) is back to normal. It might therefore take more than improved relations with the EU to boost the UK’s trade performance.

Another policy is planning reform. Reeves calls the UK planning system the single greatest obstacle to the UK’s economic success. It’s true that the rate England has built houses has fallen since the 1960s, but on a shorter-term horizon, UK investment in dwellings as a share of GDP has picked up. And at just over 4% of GDP, it’s slightly higher than the U.S., which is a country that has a lot more room to build. It’s probably right to believe that Labour will be less beholden to nimbyism than the Conservatives, and its policies will help spark an improvement in house building and other infrastructure. But how much growth those changes end up driving isn’t clear.

Labour would also seek to raise investment with its Green Prosperity Plan, by placing a time-limited tax on the exceptional profits made by oil and gas companies. Economic theory says this policy should be successful. This is because public investment spending usually triggers further economic activity, meaning it should more than offset the impact of tax increases. But it’s worth remembering that not all tax hikes are the same. Labour has said they’d scrap energy companies’ investment tax relief allowances. The CEO of lobbyist Offshore Energies UK said the measure would result in no new investments and job losses. He’s clearly talking his own book, but the main point is there would likely be some growth downsides as well as upsides from Labour’s investment plans.

The last major Labour policy goal we’ll discuss here that requires a limited net fiscal outlay is redistribution. This includes policies such as closing the non-domicile tax loopholes. The aim would be to reduce inequalities and support growth to the extent that less wealthy cohorts spend a much greater proportion of their income than their wealthier counterparts. But again, there are some downsides to redistribution that will need to be kept in mind. Labour’s non-domicile proposals will incentivize some high earners to leave the UK and discourage wealthy individuals from moving to the UK in the first place. Equally, Labour’s plans to change the way that “carried interest” (income for private equity partners) is taxed could cause funds to leave the UK.

All told, we suspect that Labour will have some success in boosting economic growth via these policies. However, the pathway to success is not guaranteed, and implementation will need careful navigation. In addition, in light of the substantial economic challenges confronting the UK, any Labour growth uplift compared to the Conservatives is likely to be moderate at best.

The UK equity market remains cheap

Even after the recent outperformance, the UK equity market remains very cheap relative to the global benchmark. This low valuation is largely because the UK has a high representation of low valued equity sectors and there’s a lack of investor confidence in the UK.

However, if there was another supply driven inflation problem, commodity and defensive equity sectors would stand a good chance of outperforming, as was the case in 2022 when the UK equity market was one of the very best performers globally. This is because commodity prices tend to rise during inflationary periods and defensive sectors tend to hold up relatively well in weak growth environments. The UK continues to have a high representation in these sectors.

UK companies leading the way

There are plenty of high-quality stocks within the UK market, world-leading businesses that are well-placed to benefit from structural growth tailwinds, while trading on reasonable valuations, often at a discount to their global peers listed overseas. Here are a few companies that are worth a mention.

Generative artificial intelligence (GenAI) has been the topic du jour over the past 18 months, with now increasing focus on a company’s ability to incorporate Gen AI functionality into product offerings to boost revenues and enhance labour productivity. RELX, a business we mentioned in a recent insight, is one of these companies – a global leading provider of information-based analytics and decision tools for professional and business customers. The company has been harnessing AI for well over a decade, and is now embracing GenAI, incorporating this functionality within its offerings, especially within its legal and scientific research tools, analytics, and databases products. Although the company has seen its shares rise over the past 12 months, its improved earnings growth prospects still don’t seem to be reflected in its current valuation.

Technology is just one reason why a lot of construction investment is expected over the coming years. UK listed Ashtead Group focuses on the U.S. construction market. It’s the second largest player in the U.S. construction and industrial equipment rental market, and we believe it’s well-placed to capture the growing opportunity set from the increase in U.S. infrastructure spending plans, particularly the growing pipeline of “mega projects”.

Another growth market is the market for consumer health products in which Haleon is a world-leader. The company was spun-out of GSK in 2022, and its portfolio of brands commands a number one market position in around 75% of its categories; plus it operates in some of the most attractive consumer categories that are less vulnerable to competition owing to regulation. This supports strong pricing power and high margins. It may be relatively cheap at the moment because Pfizer owns 18% of the company, which they’ll sell in a “slow and methodical” way.

From a broader sector perspective, the UK energy sector represents attractive value for investors. Although there are fundamental reasons that can partly explain the UK major energy companies’ valuation discount compared to its U.S. listed peers, it seems the gap is somewhat extreme. Delivering consistent results and maintaining capital discipline could make this disparity smaller.

Beyond energy’s valuation attractions, we believe the sector stands to benefit from robust demand meeting constrained supply over the medium-term for oil and gas. This should help support energy prices, and the UK energy sector’s focus on capital discipline is likely to help them continue to return significant amounts of capital to shareholders.

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