What does 2024 have in store for UK equities?

“The UK consumer is seeing real wage-growth”

The average UK consumer is approaching a period of real earnings growth. This can be seen in the ASDA Income Tracker, which demonstrates some of the strongest increases in weekly family spending power in recent history. A 12% increase year-on-year is driven by higher wages and the deceleration in inflation – and this doesn’t account for the most recent CPI figure, which fell from 4.6% to 3.9%.

Year-on-year change in ASDA Income Tracker

There is also the prospect of a general election to contend with this year, which would normally fill some investors with dread. But the Autumn Statement highlighted how quickly the two parties vying for power have moved back towards the centre ground from an economic point of view.

An election campaign would no doubt lead to some stimulatory policies around housing and tax. The clarity of an election result would likely be taken well by markets.

The outlook for 2024 is therefore one of real wage growth, a clearing event in terms of the UK election, and improving investor sentiment – all supported by low valuations.

“International investors are returning to the UK”

In recent months, we have begun to see some influential international investors show up on the shareholder registers of UK companies: Fidelity bought a 5% stake in RS Group in November, for example.

While these increased allocations are not yet meaningful, they could be a sign of things to come and that people are waking up to the value on offer in the UK. This is likely to be the key determinant of better relative performance from UK equities this year.

One area where we do have some reservations is the consensus view on interest rates, as we believe they are likely to remain elevated compared with the era of quantitative easing (QE). Fortunately, a structurally higher cost of capital favours the sort of companies we prefer: self-funding industry incumbents with strong competitive positions and durable cashflows.

“Financials underperformed in 2023, but this could be their year”

We had overweight positions in banks and life assurance companies last year which did not perform as well as we hoped. These businesses benefit from higher interest rates, and as these rose over 2022 and 2023, we expected to see positive earnings momentum and a re-rating of their shares.

Instead, the fallout from the US regional banking crisis and demise of Credit Suisse led to a de-rating, as the risk premia attached to the sector increased and investors continued to shy away. Yet, depressed valuations have allowed these companies to eat away at their equity bases via share buybacks.

With distribution yields in the mid-teens and an improving economic backdrop (lower inflation and interest rates should aid loan growth and reduce defaults), we believe the performance we had hoped to see in 2023 has merely been delayed rather than cancelled. We regard the relative underperformance of the banking sector as an opportunity and increased our weighting to it last year via new holdings in HSBC and Lloyds.

“UK small-caps could be at an inflection point”

Over the past five years, the market cap of the combined FTSE Small Cap (ex investment trusts) index has fallen by close to 50%¹. This is the result of lacklustre returns, a falling number of constituents due to M&A (mergers and acquisitions)² and an increase in share buybacks. On the last point, we cannot remember a time when more small-caps were buying back so much equity – 54 companies in the Numis UK Smaller Companies index, 12% by value, bought back more than 1% of their shares to the start of December last year³.

The result is that an inflection in flows could have a disproportionate impact on share prices. Although flows into UK equity funds were negative in 2023, this could change quickly.

While the UK has been regarded as a basket case by investors for some time, the mood now appears to be changing. Most UK companies reported more resilient trading than was expected at the start of 2023, especially consumer discretionary companies, with big gains from the likes of card maker Moonpig and pub chain Fuller, Smith & Turner.

Our fund also benefited from M&A activity, with 27 recommended offers since 2019 at an average premium of 50%.

“Quality businesses are being consistently underestimated”

For the fourth year running, Sports Direct owner Frasers Group is the stock we are most excited about. UK consumer discretionary stocks worked well for us in the second half of 2023 – even though sentiment was weak, earnings were more resilient than most people expected. Now that the macro backdrop for the UK consumer is improving markedly, with real wage growth coming through and inflationary headwinds easing, Frasers should benefit through its robust position in sporting goods and luxury in the UK.

Frasers is a well-capitalised large player with a compelling strategy of adding brands counter-cyclically to its platform. It has a strong balance sheet and usually buys back £200m of stock a year, which supports the share price. Yet the stock remains on 8x earnings.