Long UK Equities Has Become a Contrarian Trade

Investors have turned so bullish on the global economic outlook that they are increasingly shunning the UK equity market as too defensive. That leaves buybacks and M&A as among the rare positives for London stocks.

(Bloomberg) — Investors have turned so bullish on the global economic outlook that they are increasingly shunning the UK equity market as too defensive. That leaves buybacks and M&A as among the rare positives for London stocks. The UK has trailed European and US peers this year, left out of the chase for shares with cyclical and technology exposure.

Domestically focused stocks, meanwhile, are held back by a lack of reforms, sluggish growth and elevated interest rates. The political drama leading to Prime Minister Keir Starmer’s imminent departure has further deterred buyers. Global investors have cut their UK allocations to a net 37% underweight, according to Bank of America Corp.’s latest international fund manager survey.

That’s the lowest since August 2020, when sentiment was still rattled by the Covid-19 pandemic. The UK now crops up among “contrarian trades” mentioned in the survey as potential hedges against a “peak boom,” as the outlook elsewhere turns increasingly bullish. The problem for London is that it can’t offer what the market wants most right now: AI winners and stocks highly tuned to economic growth.

Tech has the lowest weighting in the FTSE 350 Index at 1.2%, while defensives like consumer staples and healthcare are a chunky 34%. Oil and gas shares account for 10%, making the benchmark more sensitive to crude prices than peers. The UK underperformed as worries about the Iran war faded following the April ceasefire, but there are structural questions that extend beyond short-term drivers.

“UK equities continue to see net outflows from domestic mutual funds,” said Goldman Sachs Group Inc. strategists led by Sharon Bell. Outflows by domestic mutual funds reached almost £20 billion ($26.8 billion) in the first quarter, she noted. “Annualized, this would be far higher than we have seen in recent years.”

The pattern among retail investors is similar, Bell and her team said, adding that inflows from this group are unlikely to increase without a pick-up in economic expectations. Pension funds and insurance companies have remained net sellers, with the pace of their disposals matching recent years, while foreign investors have been modest buyers. That leaves corporates to support the market, through buybacks and M&A. Goldman Sachs data shows strategic M&A volumes are greater in the UK than elsewhere in Europe.

The UK is indeed a fertile ground for takeover deals, with the country particularly attractive to private equity bidders and buyers with industrial targets. The acquisition battle for EasyJet Plc, Xavier Niel’s bid for Emirates Telecommunications Group Company PJSC’s stake in Vodafone Group Plc and Prologis Inc.’s offer for property company Segro Plc are among fresh examples of how appealingly priced UK stocks are for foreign bidders. “I think that’s just reflective of the valuation discount,” said Laura Foll, a UK equities portfolio manager at Janus Henderson Investors.

She points out that every sector in the UK trades at a discount to their US counterpart. Increasing deal activity is an important catalyst for the UK equity market, she said, noting the “huge amount of takeovers.” After a severe de-rating over the past decade, UK stocks now screen among the cheapest in developed markets.

The FTSE 350 trades at nearly 35% discount to the MSCI World. While sector composition explains some of that markdown, with the UK lacking expensive growth stocks and being mostly a value market, the gap remains wide when comparing like-for-like industry groups. Beyond M&A, Foll highlighted buybacks as a support for market.

“UK boards are increasingly buying back their own shares because they’re aware they’ve got this flow against them and therefore they’re creating their own demand,” she said. “So we’re seeing more and more companies in the UK announce share buybacks, including quite small-cap companies.” UK stocks could also be handed a reprieve by renewed Middle East tensions.

Oil prices have soared again and there is a risk is that investors and central banks start rethinking the impact of energy costs on inflation and interest rates. Typically, UK shares do well in times of economic uncertainty. Even so, strategists are increasingly reluctant to recommend UK equities.

Barclays Plc strategists prefer euro-area stocks to the UK, while their JPMorgan Chase & Co. peers are neutral toward the UK, citing a lack of catalysts. Citigroup Inc.’s Beata Manthey double-downgraded the UK to underweight this week. “Although valuations remain attractive, the market’s defensive and commodity-heavy composition is less appealing in an environment where earnings growth and market leadership are broadening,” the Citi strategist said.

“We continue to favor more cyclical opportunities elsewhere.” —With assistance from Lisa Pham.