Articles

• The UK market has been suffering at least a decade of chronic outflows, but we believe it may be about to turn a corner
• The FTSE 100 has quietly emerged as the best-performing developed market index since the start of the current interest rate-hiking cycle
• For those who may be sighing in dismay at a missed opportunity, in this investment update we outline reasons to remain optimistic on UK equities

‘Magnificent Seven’ vs the ‘Phoenix’ Index

Sentiment surrounding the UK equity market has been low for some time. Since the mid-2000s, the UK’s weighting in the MSCI World Index has declined from 11% to 3% (Source: MSCI, Refinitiv, as at 29 April 2024). The UK stockmarket has suffered chronic outflows as investors chase high potential returns from growth-oriented markets and as UK pension schemes have undergone a structural de-risking shift away from UK equities. But rather than revisiting well-documented headwinds to the UK equity market, let us focus on recent outperformance and why this could be an inflection point.

While the "Magnificent Seven" (Amazon.com, Apple, Google parent Alphabet, Meta Platforms, Microsoft, Nvidia and Tesla) have captured the spotlight with their impressive performance, the FTSE 100, like a resurgent phoenix, has quietly emerged as the best-performing developed market index since the current interest rate-hiking cycle started. The S&P 500 is up 23%, Europe’s Stoxx 600 (ex UK), is up 18%, while the Japanese Topix returned 15% over the same period (all figures in sterling terms).

Figure 1: FTSE 100 Outperforms Other Developed Markets

Past performance is not a guide to future performance

Source: Refinitiv, 16 May 2024

The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. There is no guarantee that the fund will achieve its objective and you may get back less than you originally invested. Wherever mentioned, past performance is not a guide to future performance.

M&A Crystalising Value

The level of M&A activity in the UK market has been notable, pointing to a market where valuations clearly remain depressed. This increase in M&A is not a surprise to us, given the valuation discount, strength of the collective balance sheets and high level of dividend yield on offer. We see this increased M&A activity as an optimistic signal for UK equities.

There have been 12 takeover approaches in the first quarter of this year. Only one of the 12 deals belongs in the Large Cap FTSE 100 index. Six are in the Mid Cap FTSE 250 index, and the remaining five are in the Small Cap ex Investment Trusts and FTSE AIM indices (Source of information: Peel Hunt, as at 31 March 2024). Although the number of bids was higher in the last quarter of 2023 than in the first quarter of this year, the size of the companies being acquired has increased materially.

Figure 2: Bid activity by quarter

Source: Peel Hunt, 31 March 2024

Passives Out, Actives In

We recognise at least some of the increased activity is due to broader macroeconomic improvement, but we are convinced that the opportunity still remains for active managers where passives lack the ability to make judgement on M&A activity.

The M&G UK equity desk has a long-standing history of determining if takeover deals are likely to offer value for our shareholders. This year alone, we have had 14 takeover approaches to companies held across our UK funds. We have played an active role in working with companies’ management teams on many of these. In one example, Direct Line was approached by Ageas in February with a cash-and-shares bid, which we felt significantly undervalued the company. As such, we actively engaged with the board and encouraged them to reject the approach.

Similarly, abrdn Property Income Trust was approached by Custodian Reit, an offer we felt mispriced the underlying assets and therefore we voted against. Having said that, we don’t reject all bids. Darktrace, a cyber security firm, has been bid for at a 19% premium by a private equity firm. Similarly, transport and logistics firm Wincanton Group sold for a premium of 104% to the pre-offer price. This deal, which offered material upside to our shareholders, made us happy recipients.

Buyback Tailwinds

A further boost to the UK market comes in the form of buybacks. UK companies have announced higher-than-average buybacks so far this year, which adds a further tailwind in total yield terms. BP and Shell bought back between 7-8% of their outstanding shares in 2023 and both continue to allocate surplus free cash flow to support share repurchases in 2024.

Figure 3: UK buybacks are well above average

UK buyback announcements in the first four months of the year.

Source: Barclays, 30 April 2024

Notably, share repurchases over the last 12 months have been skewed towards companies in the energy and financial sectors, suggesting cyclical parts of the market have an increased confidence in the economic outlook.

Figure 4: Buybacks indicate increasing confidence

Source: Barclays, 30 April 2024

We believe the increased M&A and buyback activity could be driving a change in sentiment towards UK equities, as UK firms and corporate buyers capitalise on the valuation discount relative to global peers.

Political Stability

With a much-anticipated UK General Election on the 4th of July, investor attention is understandably turning to political party manifestos. On this point, it has been noticeable to us how politically agnostic UK businesses have been, above all expressing the need for political stability. Since 2016 there have been 13 housing ministers, nine education secretaries and eight home secretaries*. We believe that recent polls indicating a working majority as a result of the next general election make up a positive catalyst for UK equities, as companies and investors alike crave stability.

Signs of Progress

There is no doubt that UK growth has been fragile, but early signs of progress are encouraging, with surprisingly good GDP data reported for the end of March. This may help to sustain positive momentum in the UK, particularly in more interest rate-sensitive parts of the market. However, we are not depending on a return to a low rate environment. In fact, a ‘higher- for-longer’ scenario could have three potential catalysts for UK equities.

The first is a stronger dollar, with the FTSE 100 a large beneficiary as over 75% of its components’ revenues come from overseas. The banking sector, which should see positive earnings momentum in this environment, is the second catalyst; banks make up approximately 10% of the FTSE All Share index. Thirdly, the UK is a low p/e and short duration market; this means that as discount rates increase, the UK market could potentially be less vulnerable to a global sell-off.

Cautiously Optimistic

A final observation is that while the UK market has its challenges, perhaps the recent strength in performance indicates a bottoming out of these headwinds. The UK’s weighting in global indices is at all-time lows and UK pension fund flows from equity to fixed income cannot go much further. Perhaps, with performance momentum, we will see international investors continue to tentatively re-enter UK equities.

As a reminder, M&G's UK equity desk offers a comprehensive suite of strategies, from income investing to small/mid-cap exposure, recovery, and sustainable investing aligned with Paris Agreement goals.

* Source: The Sunday Times, 18 November 2023.