HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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April 16, 2023

UK Backwater Tide Will Turn

Bridlington,,East,Yorkshire,,Uk,08/21/2014,Group,Of,Fishing,Boats,Waiting

What Next

So far this year, investors’ primary concern has shifted from fear of inflation to concerns over financial stability. The demise of Silicon Valley Bank galvanised markets as stress fractures emerged among US regional banks. Contracting bank balance sheets are now destabilising the US commercial real estate sector, widely tipped as the next thing to break.

Lower Rates

However, palliative deposit protection assurances and emergency bank funding measures have calmed investor nerves. Equity markets rallied from mid-March lows on a growing consensus that the interest rate cycle has peaked and will start its descent before the year’s end. The QE winners have retaken centre stage. NASDAQ is up 20% and Bitcoin 80%. As investors remember the cosy Fed comfort blanket of 2021, economically sensitive banks and industrial commodities have lagged, and the hope for a soft landing is all but gone.

It Will Get Worse

While it is rational for equities to benefit from the valuation effect of lower bond yields, equity investors are suffering from recency bias, responding with muscle memory to the last time we saw interest rates fall. Last year, investors believed rising interest rates were good for banks; they now consider falling interest rates good for equities. While this may be true if all other things are equal, the bond market says they are not. Its recessionary outlook means that risk premia and credit spreads will rise as the dash for cash becomes more desperate and widespread.

2022 is Over

However, unlike last year, the UK has not been at the centre of financial market attention. Indeed after the rolling omnishambles of 2022, from a low point in the aftermath of the Truss Kwarteng mini-budget, the UK has reverted to its tradition of keeping calm and carrying on. UK regulators dealt with Silicon Valley Bank’s UK subsidiary; the Windsor Framework agreement started to mend some EU fences; the Pacific trade deal has built a bridge to growing international markets; gilt yields moderated, and the pound sterling has strengthened. Compared to the US, with its 4000 regional banks, the UK is better equipped to regulate its small number of national lenders.

What Doesn't Kill You

Although a strong UK recovery remains unlikely, there have been upward revisions to economic forecasts. Despite market fragility, UK equities remain cheap compared to global peers. And while UK equities are not immune from broader global uncertainties, we have had our crisis early and taken the opportunity to reset the sails for stormy weather.

Fund Outflows

While the UK has strived to fortify things, funds still flowed out as private investors favour fixed-income and global tracker funds over homegrown equities. Despite its improving status for investment, according to Calastone, March was the 22nd consecutive month of UK equity fund outflows. Over Q1 2023, investors pulled out an estimated £3bn from UK equity funds and a cumulative £13bn since October 2021. The data provider reported that “the relatively strong performance of UK equities since the bear market began just over a year ago has not improved sentiment. If anything, we have seen outflows accelerate, perception of the London stock market as an investment backwater, along with the political and economic difficulties the country has been facing, have kept the pressure on to rebalance holdings away from UK shares. After years of missing out on the global bull market, a period of strong performance by UK equities has clearly provided an opportunity to cash out.”

M&A Inflows

As private investors take the time to readjust their portfolios away from historic UK overweight other larger investors are starting to show the colour of their money. Since the turn of the year, there has been an increasing flow of bid activity in the UK mid-market. While not a definitive list, these are the offers and approaches I am aware of: Hyve Group, Wood Group, Network International, Dechra, Kape, and Dignity. In aggregate, these deals amount to £10.4bn of equity trying to buy UK companies, more than three times the retail fund outflows over the same period and not far from the cumulative private investor fund outflow over the last 22 months. Some of these deals might not conclude, and not all their proceeds will be re-invested into UK equities. Yet this roster still represents a solid vote of confidence in the UK mid-market.

The Tide Will Turn

All these trends are familiar to UK investors. The tide has been going out from the UK as a destination for portfolio investors for about eight years. The current UK investor flow into global tracker funds allocates private investors into US technology companies still dominating global weightings. As an investment backwater, all but discarded by commentators as a location to list equity, the UK now represents just 5% of the worldwide index. This consensus view will change, and when its attractions become more prominent, the flywheels of momentum and indexation will compound returns for patient UK investors.

Jeremy

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