China is undoubtedly the major stock market least popular with foreign investors. Yet there is another economy with consumers who are reluctant to spend, an unhealthy obsession with residential property, and more than a decade of anti-business governments with no idea how to boost growth – but where valuations are low (relative to other markets) and sentiment has been at rock bottom.
To be fair, that could describe a number of countries – but I am, of course, talking about Britain. My comparisons are more than a little glib (for a start, China has built too much housing, while the UK cannot build enough). Still, just as there is a case for at least a cyclical rally in Chinese stocks, you can make one for the UK.
High savings and lower rates
(Image credit: Office for National Statistics)
The UK savings rate has risen significantly in recent years (ignoring the distortion caused by the pandemic). Starting from that high level means that there are savings and income that might be freed up to drive solid gains in consumer spending once people feel more confident, as Julian Cane of CT UK Capital and Income Investment Trust (LSE: CTUK) and James Thorne of CT UK Smaller Companies Fund point out.
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With inflation seemingly coming down – at least for now – there is plenty of scope for interest rate cuts. This should benefit housing-related businesses in particular: firms involved in property sectors are saying that if rates fall to 3.75% or so, the market should take off again, say Cane and Thorne. However, lower rates should reduce the blow for mortgage holders who are having to refinance expiring deals, which should be good for sentiment and consumption broadly.
All this could flow into an improvement in corporate profitability, as companies in a wide range of sectors with relatively high operational leverage benefit from a bit more demand. UK corporate profits as a share of GDP are around 20% at present, compared with a longer-run average of around 22%, notes Thorne.
Investors in the right kinds of companies (he points to brick makers as an example) could therefore benefit both from a significant boost in profits as depressed margins get back to more normal levels, plus rising valuations as the UK becomes a bit less of a pariah. Thus the upside is greater than valuations alone suggest.
A virtuous circle?
Other UK small-cap specialists are making a similarly persuasive argument. A structural bull case for the UK remains more tricky for me to believe. I am sceptical that the government has any idea how to deliver the investment that Britain needs (as shown by the chancellor’s muddled “Mansion House Compact”). Still, brokers have a solid pipeline of UK smaller companies wanting to list once valuations become more attractive, say Cane and Thorne. In that case, a cyclical upturn could still become a virtuous circle that reverses the hollowing-out we have seen in recent years and makes the market far more compelling.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
