Will political change spark a resurgence in UK equities?

After years of underperformance, UK equities could be on the cusp of a much-needed revival in fortunes as the fundamental environment becomes more stable. Alex Wright, portfolio manager of Fidelity Special Values PLC, outlines how he believes the political and economic backdrop is likely to evolve and the unloved areas of the market that could set to benefit.

The outcome of the general election had been largely anticipated with the Labour party winning a large majority. Since then, Prime Minister Keir Starmer has said his government is already working to build closer ties with the European Union, moves that could potentially boost growth. 

In terms of investment implications, it is important to note that our portfolios are not buy-and-hold strategies. A key part of our investment process is to constantly be on the lookout for new opportunities as well as remaining disciplined and taking profits in stocks that have performed well and where the risk/reward is no longer as attractive. 

When making those decisions more recently, the likely impact of the elections have been one of many inputs. If I had to single out two decisions where this has played a role, I would point to the recent addition to our National Grid holding, after it fell on the rights issue announcement. When the company recently carried out a rights issue to raise £7 billion to help fund a five-year £60 billion investment plan, its stock price fell on investor worries over future earnings and dividends.

However, we believe the stock will be a key beneficiary if a newly elected Labour government increases the speed of the build out of renewables as it hopes to do. The company is very much part of the solution in terms of the need for more investment and thus far less likely to be targeted as source of tax revenues. 

On the flip side, we have reduced our North Sea oil and gas exposure in response to the fact that Labour has doubled down on its removal of the North Sea investment allowance, which clearly hurts the outlook for the sector.

Positioning against an improving backdrop

In addition to a stabilising political backdrop, we are also encouraged by the tentative signs of improvement in the UK economy. A degree of uncertainty persists, but inflationary pressures are gradually easing and growth expectations improving. On the ground, companies have proved surprisingly resilient, and we are encouraged by the performance of our holdings in the recent reporting season. 

More broadly, it is important to note that our portfolios remain well diversified, with around 100 holdings across a range of industry sectors. Financials remain the largest absolute sector exposure given very attractive valuations. Higher interest rates have allowed banks to significantly improve their profitability, while their capital positions are far stronger than they were pre-Global Financial Crisis. Our holdings are diversified in terms of geographic and banking model exposure, with idiosyncratic factors predominantly driving their growth. 

A higher interest rate environment has also been positive for life insurers, and their earnings continue to benefit from an acceleration in the pace of pension fund re-risking. Meanwhile, non-life insurers are benefiting from the improving pricing environment and moderating cost of insurance claims. 

Elsewhere, there has been an uptick in our exposure to other GDP-sensitive sectors. We have been finding new ideas in cyclical areas such as industrials, advertising and staffing and also added back into select real estate stocks and housing related names of late, where demand appears to be stabilising and valuations remain low. Conversely, we remain meaningfully underweight resources, a reflection of our lack of exposure to the large miners given our negative outlook for iron ore and thermal coal, as well as the reduction in our energy exposure.  

In terms of geographic exposure, our holdings generate just under a third of their revenues domestically. This is somewhat higher than the FTSE All Share Index and reflects the fact that buying UK stocks does not necessarily mean only buying the UK economy. With its high dividends and low valuations, we believe the UK market offers better prospective returns than many other asset classes, including global equities.

UK valuations remain attractive 

UK equities continue to trade at a wide discount compared to other global markets, despite an improving corporate earnings outlook and attractive dividends. This is being acknowledged by some market participants, and we have seen strong acquisition interest from overseas corporates and private equity firms, with seven of our holdings being subject to bids so far in 2024. 

In summary, we believe we are well positioned to benefit from the improving economic backdrop and we remain excited about the opportunity set on offer. Our holdings trade at a meaningful discount to what we think is an already cheap UK market, despite resilient earnings, superior returns on capital and relatively low levels of debt. This quality profile gives us confidence that we can continue to deliver attractive returns to investors.