14 March 2024

Rule Britannia?

Buoyant consumer confidence, falling inflation and attractive opportunities in mid and small-cap companies all point to a far more resilient UK economy than common consensus would indicate, writes Guy Anderson, Portfolio Manager at The Mercantile Investment Trust.

The prevailing narrative surrounding the UK and its economic performance has been almost uniformly negative, and this, alongside various external factors, has been weighing on investor sentiment and pushing UK valuations to very low levels.

Forecasters entered 2023 expecting a recession, but those expectations were gradually revised up over the year as it became clear that the domestic economy was proving to be more resilient than had been presumed. The improvement in the economic outlook is beginning to be reflected in corporate outlooks – the December composite Purchasing Manager’s Index, which measures changing conditions in the goods manufacturing industry sector, registered a seven-month high at 52.5, with the service sector particularly strong at 53.8 – both indicating economic growth. 

Looking forward, there are several reasons to be optimistic. UK inflation, which for a period appeared to have become ‘stickier’ (i.e. where prices do not quickly adjust to fluctuations in supply and demand) in comparison to other advanced economies, has reverted down to the G20 average. Meanwhile, consumer confidence has been recovering strongly and real wages have shown positive year-on-year growth since May 2023, after 13 consecutive months of negative growth. A sharp decline in gas prices and expectations for this to feed through to lower household energy costs, as well as the expected tailwind from the increase in living wages, pensions and benefits from April 2024, bode well for the domestic consumer. 

Our view is that now is an opportune moment to be investing, and in the mid and small-cap part of the market we are finding many attractive opportunities that we expect to deliver over the long term. This part of the market has suffered a drastic valuation de-rating (i.e., a downward adjustment in a company’s valuation multiples) in recent years – if we look back at the period between December 2019 and December 2023, the forward price/earnings (P/E) ratio on the FTSE 250 excluding investment trusts has declined from 15x to 11x. For context, the forward P/E on the S&P 500 has increased from 18x to 20x over the same period. Moreover, the FTSE 250 now trades on the same rating as the FTSE 100, in contrast to the significant premium observed historically, which has broadened the investment universe for Mercantile. 

Of course, we cannot say for certain how far this elastic band can stretch, but the de-rating cannot continue ad infinitum – and could ultimately reverse. Smaller companies tend to have higher domestic exposure than larger companies, and we expect that as we enter the initial stages of a possible monetary policy easing cycle, the prevailing narrative will begin to change positively, which would favour these companies. Many corporate buyers seem to agree with our view, given the recent number of acquisitions of UK companies, and the sheer volume of share buybacks currently being undertaken across the UK market. 

Consumer confidence has been recovering strongly and real wages have shown positive year-on-year growth since May 2023.

We are currently particularly excited about some of the consumer-facing sectors, as sentiment remains negative and valuations are low, while prospects may in fact be improving – with the UK consumer in aggregate experiencing sustained real wage growth again and consumer confidence picking up. Within this area we absolutely prefer those companies that have more levers under their own control and can benefit from market share gains. We also continue to see attractive opportunities in the technology sector, given strong corporate appetite to invest in IT and its increasing importance to economic activity.

In the near term, we expect that financial markets will continue to be heavily influenced by the inter-connected forces of inflation, monetary policy, and the impact of these upon economic growth expectations. As we look ahead, while the risks cannot be ignored, particularly from inflation (which may be influenced by supply chain disruptions and energy price fluctuations associated with escalating conflict in the Middle East) and tighter financial conditions, this is more than reflected and priced into many UK stocks. We remain optimistic given the improving domestic economic outlook and the opportunity to invest in high-quality, resilient companies that can invest capital at high returns to drive long-term earnings growth. As an indication of our positive view, the Trust is currently deploying gearing of c.13% well above the historical average.

Guy Anderson
Portfolio Manager at The Mercantile Investment Trust plc.

The Mercantile Investment Trust plc. Registered office:
60 Victoria Embankment, London EC4Y 0JP.
Company registration number: 20537

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