Investors have been rattled as the seemingly relentless gains of the US stock market gave way to a choppy start to the year.
Concerns over inflation and the Fed tightening its monetary policy have sent tech shares into a slump since late 2020, while the prospect of military conflict between Russia and Ukraine has also done little to quell nerves.
The S&P 500 dipped as much as 10 per cent in January and is now down 5.5 per cent in the year to date, while the tech-heavy has plummeted 10.5 per cent.
In contrast, the FTSE 100 has pushed 0.47 per cent higher in the same period, prompting some analysts to suggest once more that UK shares look a good bet, flagging them as potentially undervalued after their perennial laggard status in recent years.
The FTSE has had a stronger start to the year than US markets, which have been hit by a tech selloff
Investors will certainly get paid for holding UK stocks. The current dividend yield of the UK stock market is around 3.5 per cent, a premium of 2.4 per cent to the 1.1 per cent yield available from 1–year UK government bonds.
But will they also get the share price growth they desire? Some argue that their relatively cheap nature gives UK stocks more headroom to rise than expensive rivals.
Jason Hollands, managing director of investment platform Bestinvest, points to the Cyclically Adjusted Price/Earnings (CAPE) ratio as a good barometer of market valuations.
‘UK equities are currently trading at around 17 times long-term earnings.
‘While not a screaming bargain, this does nevertheless represent a very steep discount to global equities overall and the US market in particular, where the CAPE ratio is now at 37 times long-term earnings – a level that has only ever been higher during the Dot Com Bubble.’
But the UK has been a cheap market for some time and not much loved by investors, big or small.
It has a relatively high exposure to banks, miners, and oil and gas stocks which have underperformed the tech sector over the past decade.
Hollands says: ‘Unlike the US market, the UK stock markets has relatively little exposure to ‘growth’ sectors like technology which have seen valuations balloon during recent years as key beneficiaries of a period of ultra-low interest rates, benign inflation and a prolonged period of people working, shopping and entertaining themselves at home.’
These ‘old economy’ sectors tend to be more sensitive to market volatility so were hit hard by the pandemic in 2020.
But as the tech sector wobbles in the face of interest rate hikes and tighter monetary policy, could it be a good time to buy UK stocks?
Could US volatility spread to the UK?
One risk is that the UK starts to feel the effects of the selloff in the US.
Scottish Mortgage Investment Trust, which has exposure to high-growth US stocks like Tesla, as well as other disruptive growth companies around the world has slipped 15.64 per cent since the start of the year.
UK tech darlings Darktrace and Deliveroo have also seen their prices plummet. Darktrace, which specialises in cyber defence, fell as much as 7 per cent and is now trading down 2 per cent.
Deliveroo, by contrast, has slumped 27per cent since the start of the year.
When investors pile into growth stocks they usually do so on the expectation of future income streams, so when borrowing costs and inflation rise it creates further uncertainty about the value of future earnings.
Investors are being more tempted by the certainty of profits today rather than the promise of jam tomorrow – with the easing of the pandemic that is lifting Covid-hit stocks further fuelling this effect.
Recent months have seen investors backing away from growth stocks, but how likely is it that the volatility felt in US markets spreads across the Atlantic?
‘The US represents such a significant chunk of global stock markets, gyrations on that side of the Atlantic can have a bit of a ricochet effect across the globe, driving sentiment,’ says Hollands.
Stuart Clark, portfolio manager at Quilter adds: ‘More often than not, if the US sneezes, the world catches the cold. Given the size and importance of the US market it is natural that any volatility seen over there will seep into the UK market too.’
But given the structure of the UK market and its value tilt, it may well prove a more appealing place to invest at the moment.
‘The names that make up the UK market have more favourable characteristics in an inflationary world where interest rates are rising. This means the volatility might not be as pronounced and those companies that have competitive market positions with strong pricing power could withstand the increased costs of doing business,’ says Clark.
Hollands adds: ‘The frenzy of M&A bids by international investors for UK companies over the last year, tells you clearly that overseas buyers spy value in the UK.’
Is it a good time to invest in the UK?
Investment giant JP Morgan last week told its clients to buy into the ‘exceptionally cheap’ UK markets and upgraded its view of UK shares to ‘overweight’.
Financial and energy stocks have certainly staged a comeback as commodity prices rise and the market prices in another rate rise next month.
James Lowen, senior fund manager of JOHCM UK Equity Income Fund highlights the financial sector is particularly best placed to benefit from an interest rate hike.
‘It will help increase their profitability and importantly return on capital. Excess provisioning across the Covid period coupled with strong employment trends mean future bad debt costs will be low.’
‘All our UK banks also have excess capital, are buying back shares and increasing dividends. They are all on very low valuations.
‘There is a similar positive narrative around the insurance sector where we expect a ‘Brexit’ regulatory dividend in the early part of this year.’
HSBC, Barclays and Lloyds are all up in the year-to-date, gaining 16.22 per cent, 4.29 per cent and 6.89 per cent respectively.
‘In our view this is absolutely the time to relook at the UK market and increase weightings,’ says Lowen.
‘Rising interest rates, changing leadership towards value, financials and commodities is the key that could lock this undervaluation and help sustain the trend we have seen year to date – namely UK outperforming.’
Darius McDermott, managing director of Chelsea Financial Services, is far less bullish on the UK market.
He notes it ‘has been cheap for a reason… When talking about mega and large caps, I would still rather pay up for overseas stocks which may be a bit more expensive but have better growth prospects.’
‘A month ago would have been a good time [to buy UK stocks], now the UK has hugely outperformed in the first few weeks. There are some great US stocks which have been cut in half. I would rather be adding to the US at this stage.’
Investing in the UK: Fund ideas
If investors do choose to increase their exposure to UK equities, what opportunities are there away from financials and energy?
‘The increased focus on environmental issues could indeed provide a great opportunity for specialist companies in the UK to shine,’ says Lowen.
‘The challenge being, will these developments occur on the listed market or in private vehicles like Williams Advanced Engineering?’
This impact of product development will be most visible in small caps where breakthroughs can significantly change a company’s earnings profile.
Lowen says: ‘There is typically greater volatility and lower liquidity down the market cap spectrum and so investors have to be willing to take on this additional risk to potentially harvest the return.
‘While not a dedicated small cap manager we do invest with Derek Stuart at Artemis who has carved a niche as a special situations manager.
‘His focus mixes on smaller companies with interesting product mixes through to larger companies that may have suffered and through management change or self-help programmes can turn around and regain their previous strength.’
Both funds look to provide an income yield higher than the FTSE All-Share Index and invests in companies that exhibit above average income generation potential.
Jupiter UK Special Situations may be another option for investors looking for exposure to UK equities.
Manager Ben Whitmore focuses on companies he considers to have undervalued share prices.
‘Whitmore is a bottom-up stock picker and though he has a focus on value, he also looks for ‘quality’ company fundamentals. He looks to hold stocks for the long-term – between three and five years,’ says Bestinvest.
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