If 2023 is anything like 2022 then the UK may be in for a bumpy ride – inflation surged, interest rates soared, currencies swung, and UK the government clashed.
However, while macroeconomic headwinds remain, there is reason for optimism for UK equity investors who are taking an active approach to managing the risks and identifying the opportunities.
Stabilising global inflation will calm markets
Fortunately, an easing of global inflationary pressures is beginning to unfold. Data released in November showed that US consumer prices had risen by 7.7% over the past 12 months, falling short of the 8% estimates.
In December, China announced a reversal of key zero-Covid policies after weeks of civil unrest. And indeed, global commodity prices have moderated since their extreme volatility earlier in the year.
As inflation looks like it is peaking in the UK, the news of a cooling backdrop in the US has helped drive a re-rating of equities and a pullback in government bond yields domestically.
Inflation in the UK is expected to continue to fall back from highs over the next few months although the impact from changes in consumer energy support policy will likely be a key determinant as to how this plays out.
And central bankers can start to take a breath
Assuming an easing in headline inflation figures, we expect the central bank to be nearing a peak in its monetary tightening programme. The Bank of England recently made steps to reduce its balance sheet, embarking on a programme of quantitative tightening in the fourth quarter of 2022.
Higher interest rates mean higher financing costs for corporations and consumers. Combined with the tighter flow of liquidity, this may present some short-term challenges for UK equities whilst the positive effect of moderating inflation takes its time to embed into supply/demand habits.
Key economic concerns are the length and depth of this inevitable slowdown – investors remain closely focused on the central bank response as the risk of a policy mistake is increased.
As the short-lived ‘Trussonomics’ regime unwinds, the central bank at least has some relative market stability in order to play its best hand. Market-inferred peak base rates have moderated by more than 100 basis points since the (not so) mini-Budget was announced earlier in 2022. The perception of a safe pair of economic hands in the Rishi Sunak/Jeremy Hunt duo has improved sentiment to the UK into 2023.
With gilt yields stabilised, and an economic catastrophe seemingly circumnavigated, relatively benign markets will be well received by the Bank of England as they execute monetary policy over the coming months.
The extreme impact of inflation is not universal
One must be reminded that not all consumers are proportionately impacted by the enduring cost-of-living crisis consuming the UK, which remains in a position of strength from the perspective of excess household savings – savings accumulated throughout the Covid-19 pandemic are now earning an attractive rate of interest income.
Furthermore, the UK mortgage market has evolved since 2005 – the last meaningful period of central bank tightening – when 70% of mortgages were financed on variable terms. Today, only 14% of the UK mortgage market is financed with variable rates.
The extent of fixed-rate mortgage financing and indeed outright home ownership within the UK should continue to partially offset the cost-of-living burden instilled by soaring consumer energy bills. But we do expect a degree of consumer caution to remain until broader costs begin to moderate.
The labour market remains strong relative to history
The labour market has continued to demonstrate resilience throughout this period of volatility. Although latest data indicates that unemployment rose to 3.7% in the third quarter of 2022 and that vacancies dropped for the fifth consecutive quarter, one must be reminded that the labour market remains buoyant relative to historic levels.
Signals such as a falling labour inactivity rate are indicative of employment re-engagement particularly amid the over 50s, as soaring costs prompt ‘early retirees’ back into employment.
Thus, we do not expect a surge in the unemployment rate, which should provide some protection against the risk of a prolonged, severe recession.
Equity value remains, particularly compared to global markets
Despite the relative strength of the UK equity market throughout a period of heightened volatility, investors remain mindful of the value that remains.
The UK market is trading on a forward price-to-earnings (P/E) ratio of around 10x – 20% beneath its 15-year median – and offers a dividend yield of 4%.
Contrasting with the US, trading on a forward P/E ratio of around 18x – 12% above its 15-year median – and a dividend yield of 1.7%, UK equities look cheap.
An economic slowdown is widely anticipated across global markets and as such, should investors continue to address the notion – is this bad news already priced into UK assets?
The UK market remains forward-looking, and in our mind is pricing in an excess of pessimism given where valuations are today. Thus, the attractiveness of the region is enhanced to investors as evidenced by ongoing M&A activity, as indeed are the prospects for continued resilience through 2023 and beyond.
Ben Russon is co-head of UK equities at Martin Currie. The views expressed above should not be taken as investment advice.