The UK equity market has been a laggard among global peers since Brexit, but bargain-hunting investors have been showing renewed interest. Dina Ting, Franklin Templeton ETFs’ Head of Global Index Portfolio Management, explores the positive trends that are making a case for holding UK equities.
Having endured many plot twists since the United Kingdom voted to leave the European Union (EU) in 2016, the UK stock market has been a notable laggard among global peers.
As of the end of July 2023, US-listed UK mutual funds and exchange-traded funds continued to see year-to-date outflows of US$560 million. For the past 12 months through July 31, 2023, UK equity outflows totalled US$1.1 billion, making the market particularly unattractive amid the outperformance of US and European stocks over the same timeframe.
But with a flagging US stock market, investors are again eyeing the UK’s undervalued and long-unloved market. Outflows have recently slowed in the United Kingdom as investors have been signalling a return of some optimism for the economy’s enticingly cheap investment prospects. Falling energy and stabilizing food prices helped cool Britain’s annualized consumer price inflation rate from June’s 7.9% to July’s 6.8%. While the UK’s inflation rate is still far higher than the Bank of England’s 2% target, we believe its recent downturn could suggest a turning point. The Conservative Government—trailing significantly in polls ahead of a general election expected in late 2024 or early 2025—has made bringing down inflation one of its campaign priorities.
Compelling valuations
Undervalued in absolute terms, relative to their own history and compared to other developed markets, British stocks remain in the bargain bin. In our analysis, they appear particularly cheap against equities in the United States and Japan, whose weightings dominated the FTSE Developed Index at the end of July with 67% and nearly 7%, respectively. The United Kingdom held a 4.3% weighting in the index.
Corporate fundamentals
The FTSE UK Capped Index’s top holdings—banking and financial services group HSBC Holdings and energy and health care giants Shell, BP, Astrazeneca and GSK—target revenue from foreign customers and sales abroad, which presents investors with the opportunity to gain global exposure without overpaying for it. The index also has slightly more than a 30% weighting to defensive sectors, such as health care and consumer staples, which may help it weather market volatility.
UK economy
Recent news about the UK’s economy still shows some headwinds, but the International Monetary Fund (IMF) announced in May that it no longer anticipates a recession this year. July saw upward revisions to its previous estimate of gross domestic product (GDP), which means the UK’s debt ratio for recent months saw an encouraging improvement. Public sector debt at the end of July 2023 was estimated at 98.5% of GDP—signalling improving debt.
But there’s more to the UK’s economic picture. The UK Department for Business, Energy & Industrial Strategy together with the UK Space Agency announced the allocation of its largest-ever research and development budget, worth US$50.2 billion, to drive forward the government’s ambitions as a science superpower. Allocations will deliver on the government’s “Innovation Strategy,” including its ambition to increase total research and development investment to 2.4% of GDP by 2027.
Should the Labour party win the next general election, Labour politician Rachel Reeves recently ruled out any version of a wealth tax on the richest in society. She told the Sunday Telegraph that Labour would instead do “whatever it takes” to attract business investment into the United Kingdom.
Government measures to boost the UK’s growth potential also include agreements to restore a smooth flow of trade within the UK internal market known as the “Windsor Framework,” in addition to an expansion in the range of businesses able to benefit from them. IMF officials have also recently stated that a more measured approach to reviewing retained EU laws “will help reduce Brexit-related uncertainty (while) . . . enhanced childcare support and tax relief on investment in plant and machinery introduced in the spring budget should support labour participation and business investment, respectively.”
Taken together, these points make for an appealing case for investors to hold UK companies that seem to be signalling good prospects and perhaps a recognition of undervalued stocks amid a slew of buybacks across several sectors to boost shareholder returns. Consider that BP, Diageo and Unilever are among the FTSE UK Index companies that launched buybacks in 2023. While Shell (the largest holding in the index) reported lower-than-expected second quarter earnings, it also launched a US$3 billion share buyback program. In addition, Lloyds Banking Group and Reckitt Benckiser both announced plans in July to raise dividends.
For those implementing global asset allocation, we often tout the benefits of single-country and regional ETFs as tools that can help investors create differentiated outcomes. In our opinion, selecting cost-effective investment vehicles, such as single-country ETFs that are tailored for precise implementation, can make sense in this environment for many investors.
