Gervais Williams and Martin Turner, managers of the Diverse Income Trust, look in the cupboards of the UK stock market and ask if the right ingredients are now in place to cook up some more growth?
For information purposes only. The views and opinions expressed here are those of the authors at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
2023 has been defined once again by an ongoing stream of UK OEIC redemptions. Whilst this has been a feature for the last two years, it is noteworthy that international investors appear to be marginally increasing their weightings to global equity income stocks, which includes many UK quoted stocks. So, whilst the share prices of larger UK quoted companies would normally have drifted down on heavy local selling, to date this has been offset by international buyers.
There has however been a different pattern within AIM-listed equity income stocks. These are not of interest to international investors, so the ongoing UK OEIC redemptions have led to an overhang of sellers, and as a result their share prices have progressively declined. Although equity markets staged a recovery from September 2022, the share price recovery within AIM-listed companies has been tepid at best. In fact, as bond yields rose over recent months, and global equity markets peaked, the FTSE AIM All Share Index marked a new three year low at the end of September.
Meanwhile, rising interest rates tend to have a depressing effect on economic activity, albeit with a time lag. Therefore, the longer that US or UK interest rates remain elevated, the greater the risk that they precipitate an economic setback. Furthermore, over the last two months energy prices have appreciated, which may add to the cost pressures for businesses.
As the economy has avoided a global recession to date, there is some hope that if central banks can cut interest rates relatively rapidly from here, then we may avoid one altogether. A recent Bank of America Global Fund Managers survey notes that around three quarters of fund managers are now working on this assumption.
If they are right, we would expect the uptick in the performance of markets to broaden to include mid and small-caps. Indeed, there some early indications that investors may be adding to their UK holdings outside of the mainstream stocks over recent weeks, albeit only isolated examples as yet. As AIM-listed equity income stocks stand on what appear to be absurdly low valuations compared to those in the FTSE 100 Index, we believe they have plenty of upside potential. Furthermore, as FTSE 100 Index itself stands on a low valuation compared with international comparisons such as the S&P 500 Index, we consider that when the features of the UK market come back into favour, it has the scope to outperform in terms of scale, and over a super cycle in terms of duration.
In the absence of Quantitative Easing, government bond issues are now absorbing considerably greater sums of investment capital than previously. Hence, over the three-months to September, the valuation of government bonds, particularly US government bonds, deteriorated. As the valuation of government bonds declined, so too did the valuations of global equities, but interestingly this trend was not so apparent within the FTSE100. Indeed, mainstream UK equities continue to be the best performing mainstream stock market over the last two and three years in US dollar terms.
In our view the recent changes in market trends have all the makings of a new UK stock market super cycle. As a broader range of global investors increase their low-beta holdings, we believe the FTSE 100 Index will breakout to new highs, similar to recent moves in the Japanese market. Hence, we anticipate that the recent outperformance of FTSE 100 Index will not only persist but may accelerate from here. As this new pattern becomes more recognised, we expect UK OEIC selling to dry up, and ultimately to be reversed.
In our view, the principal beneficiary to the change in UK OEIC flows will be stocks listed on the AIM market. After their substantial underperformance over recent years, many AIM stocks stand on absurdly low valuations. When UK OEIC selling ceases, even modest sums of new cash can drive up small-cap share prices very substantially.
When small-caps thrive, they create local skilled employment, drive local productivity improvement, and ultimately pay increasing taxes to the local exchequer. If anything, therefore, the health of capital flows into UK-quoted small-caps is more important to the UK government than that of UK large-caps. The chancellor specifically voiced these points in his recent Mansion House speech. Alongside this, at Premier Miton we are proposing that a portion of annual ISA investment is ring-fenced for UK-quoted companies. Judging by subsequent press comments, the chancellor may be set to announce a change along these lines in his Autumn Statement in November.
If he does so, we would see this as a potential game changer. Renewed UK ISA flows allied with growing enthusiasm from private investors for UK small-caps have the potential to transform UK OEIC flows. The small cap effect is normally evidenced by their long-term outperformance of mainstream UK stocks. If the UK majors continue to outperform global comparatives as we anticipate, and if UK small-caps outpace them as they have in the past, then UK small-caps will enter a new period when they outperform most international stock market strategies as well. This pattern could persist for a super cycle decade or two in our view. The key point is that these assets are starting at ultra-low valuations, along with ultra-low institutional weightings. Hence, we consider that all the right ingredients are now in place for small-caps to come back into favour.