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It is hard to justify the UK’s discount vs the US

05 June 2023

After a tough few years for the UK, things are starting to look up. The chances of recession have dropped, political stability has returned and profits are cheap. So when will investors notice?

The UK is under-owned, under-priced, and underestimated. I believe it’s facing neither recession, nor a regional banking crisis, nor another populist election campaign.

Instead, households are feeling more upbeat than at any time since the invasion of Ukraine, company earnings are holding up well and business is once more seen as a positive rather than an incumbrance by the leaders of both the government and the opposition. Many people are scratching their heads.

What happened to the baked-in recession for the UK that everyone from the International Monetary Fund (IMF) to the Bank of England had forecast? Having frontloaded a fair amount of economic and interest-rate pain last autumn thanks to the infamous Liz Truss/Kwasi Kwarteng ‘mini-Budget’, we’re now in the unusual (and frankly surprising) position where the US is expected to slide into recession while the UK avoids it.

British GDP growth contracted 0.1% in the third quarter of last year, but posted a 0.1% expansion in both the fourth quarter of 2022 and first of 2023. Not heroic, but better than expected. And crucially non-negative, during a nervous period when energy bills were high and mortgage rates were jumping.

We should now be over the worst of skyrocketing bills, especially for energy. Refinancing debts will still be a tough shock for many, but the UK’s flexible mortgage market could be helping here. It’s relatively simple for borrowers to extend their loan term to significantly reduce their monthly payments.

This quarter should give us more evidence of how very swift rate rises are impacting the economy. Unemployment has started to tick up in recent months, albeit at 3.9% it remains near all-time lows.

Wages are still growing strongly, though, which belies weakness in the jobs market. Public sector paypackets were up 5.6% in the year to February, the highest in 20 years. Private sector increases were even stronger, at 7%.

House prices, too, defy the doomsayers. Consumer confidence is now at its highest level since before the start of the Russian invasion of Ukraine. Investment intentions have picked up. Sterling is the best-performing G10 currency year-to-date. Remember when the tabloids thought the pound and the dollar would hit parity? It’s now back trading around $1.25.

And yet the UK stock market is still pricing in a recession, which cannot be said for the US. The FTSE All-Share is trading below 11x, while the US is trading on an elevated 18x. With the possibility of earnings downgrades thanks to the rapid rate-tightening cycle, having a reasonable valuation cushion becomes critical.


It’s the policy, stupid

Global investors have told me the argument against the UK was never about the fundamentals of the economy or the companies that are based here. Instead, investors steered clear because of political risk.

This has now faded considerably. The Windsor Framework removes the risk of a trade war with our largest partner, strike-breaking union wage deals look imminent, and the Scottish independence movement has effectively melted away.

We have a centre-right government pursuing sensible fiscal policy and by 2025 we will likely have a centre-left government pursuing sensible fiscal policy. In other words, an ordinary, sanguine political climate. In the context of another mud-slinging US election in 2024 with at least one radical populist candidate, political risk in the UK just isn’t the issue it was.

The UK is starting to look like the grown-up in the room again. The clearer that becomes – as the US debt ceiling standoff rattles markets and partisan rhetoric ratchets up ahead of next year’s presidential elections – the harder it will be to justify a 30% discount for British businesses.

Alexandra Jackson is manager of the Rathbone UK Opportunities fund. The views expressed above should not be taken as investment advice.

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