The Coronation of The King and The Queen Consort, with all the flag-waving, street parties and cucumber sandwiches that entails, provides Brits with some cheer after a tough period for the economy and the domestic stock market. Could the start of the era of King Charles be a good moment to buy British?

The UK has had a rough ride in recent years. The disruption created by the 2016 Brexit vote has dented confidence and investment, while economic growth has been lacklustre. The International Monetary Fund recently forecast that the UK would have the worst economic performance of any advanced economy, with a 0.6% contraction in 2023.

The gloom is reflected in relative returns from the UK stock market. Over the past decade, the MSCI World Index has delivered an average annual return of 9.4%, compared to just 3.7% for the UK. International investors have been deterred by political instability and the prospect of stronger growth elsewhere, notably from the large US technology companies.

A changing environment

There are reasons to believe these factors may not weigh as heavily over the next year. Much of the weakness in the UK stock market is a result of its sector composition. Unlike the US, with its fast-growing technology stocks, the UK is an unfashionable blend of old-economy value sectors such as resources, banks and utilities.

At a time when interest rates were low, investors were focused on high growth businesses with the promise of future profits. There was limited appeal in the cash flows and dividends that traditional UK businesses were making in the here and now. As interest rates have risen, the tables have started to turn. Higher interest rates mechanically reduce the value of future cash flows, disproportionately hitting higher growth businesses whose value is weighted to the future. This benefits the UK market relative to higher growth markets.

The valuations of UK companies also look appealing compared to their international counterparts after a decade where they have declined. The UK stock market trades at a forward price to earnings ratio (a measure of share price relative to company earnings) of 10.3x. The MSCI World average is 15.9x. Investors pay less for the earnings from UK companies than almost anywhere else in the world. We see this as an anomaly that should ultimately correct when sentiment towards the UK revives.

If you think the UK market has had a tough time in recent years, then spare a thought for small and mid-cap stocks. These areas have borne the brunt of concerns about the UK economy and continue to languish. The FTSE 250 and FTSE Small Cap indices produced a total return of -18.8% and -14.0% in 2022, significantly lagging the FTSE 100 which produced a total return of +3.0%. The drivers of this divergence cannot be entirely explained by operational performance, creating some interesting opportunities among smaller stocks.

A potential revival?

The UK economy is adjusting to the reality of higher interest rates, creating a headwind for consumers and businesses as fixed rate loans reach the end of their term. Yet there are also signs that some headwinds are turning into tailwinds.

The energy crisis has not been as bad as feared. There were concerns that fuel shortages and high costs could halt manufacturing and cripple household budgets over the winter. However, energy prices have been falling as governments have successfully re-engineered their energy mix to reduce reliance on Russia. The fear of an energy crisis had driven down UK stocks, so it seems logical that the removal of that fear should drive the market back up. Lower energy prices improve the outlook for consumer-disposable income, corporate profitability and the Government’s fiscal position.

Some political and economic stability has been restored to the UK after the disruption created by ‘Trussonomics’. Sterling is responding positively to signs that the Government has got a grip on the economy. The signing of the Windsor Framework and joining the Trans-Pacific Partnership appear to recognise the need for less friction in the movement of goods with our major trading partners. Trust will take time to rebuild, but the UK’s credibility is slowly being restored.

We are finding many well-managed UK companies trading at exceptionally low valuations. The question remains what the circuit-breaker will be to cause a change of heart, allowing the value inherent in UK stocks to be realised. Fund flows have been unhelpful for some years, with UK investors typically reducing allocations to their home market from over 30% to less than 5%. Net outflows of £1.4bn from UK equity funds in February would suggest that this exodus is yet to turn, but it is becoming easier to envisage a slowing in the pace of outflows from UK equities as the bulk of the de-allocation is behind us.

The improved performance of UK stocks can become self-fulfilling, as asset allocators begin to worry that they do not have enough exposure to an index that is outperforming. The same logic applies to M&A where corporate bidders suddenly feel under greater pressure to consummate the deal they have been considering for years.

Where does this leave investors?

The UK outlook is mixed, but it would only take a small change in sentiment to create a significant impact on the stock market, given the entrenched negativity that exists today. It is not always easy to predict the trigger ahead of time, but investors need to be ready, particularly in areas such as smaller companies where sentiment can move quickly.

UK plc is in solid health, with far stronger balance sheets than at the time of the last crisis in 2008. UK listed companies have encountered exceptionally challenging conditions, with issues including Brexit, trade wars, Covid and Ukraine. To have come through these issues would indicate a level of resilience that hasn’t been reflected in valuations.

The UK market has another trick up its sleeve: income. It remains a source of high and stable dividends. The FTSE All Share’s dividend yield is 4.0%, far higher than most of its global peers. This dividend yield also appears sustainable, with a payout ratio of less than 40%, well below the average level of the past decade. We see opportunities to find dependable dividends across the market, including mid caps and small caps. We also see interesting dividend opportunities within the FTSE 100, with Resources and Financials largely to thank for the solid 5% dividend growth that the UK market achieved in 2022.

The coronation of King Charles may coincide with a stronger period for the UK stock market. Few people would challenge the view that there is plenty of value inherent in the UK market. We just need a little more confidence to unlock that value. That would be another cause for celebration in 2023.

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