The UK has defied widespread predictions of recession in 2023 but the outlook remains challenging.
Quarterly GDP growth has been declining from its already modest levels throughout the year and there was no GDP growth in the third quarter of this year.
The latest forecast from the Office for Budget Responsibility (OBR) puts GDP growth at an average of 1.6% between 2024 and 2028, and it expects inflation will not return to its 2% target until the end of 2025.
The OBR is not alone in its forecast of low growth for the UK. The latest OECD Economic Outlook forecasts GDP contracting by 0.4% in 2023 and growth of only 0.2% in 2024, compared with global growth of 2.2% and 2.7%. The International Monetary Fund forecasts growth of 0.5% in 2023 and 0.6% in 2024 for the UK, compared with 1.5% and 1.4% for advanced economies.
The performance of the UK economy has been reflected in continued underperformance of UK equities. So far in 2023, the FTSE All Share has produced a total return of just over 4% compared to a gain of 13.5% for the MSCI Europe ex UK index and 20.3% gain produced by the S&P 500.
The UK is currently our least favoured developed market, and we have been steadily reducing exposure in many of our portfolios
Currency movements have been considerable this year, but even adjusting for sterling weakness for much of this year the underperformance has been significant (MSCI Europe ex UK up 10.3% and S&P 500 up 14.8%).
Inflation is falling significantly and CPI dropped to 4.6% by the end of October from its peak of 11.1% in October 2022. However, headline inflation has been more persistent than in the US or Europe. Core inflation (excluding food and fuel prices) remains elevated at 5.7% and has seen only a modest decline from its peak of 7.1% in May this year. Wage inflation remains near record levels and is currently running at 7.9%, unemployment remains low and although job vacancies have fallen from their peak they remain far above pre-pandemic levels.
Rising wages and the buoyant jobs market has the potential to fuel price inflation, and this means the Bank of England is under pressure to keep interest rates high to get inflation under control. But with the economy already slowing, this means the possibility of recession remains elevated.
The UK is currently our least favoured developed market, and we have been steadily reducing exposure in many of our portfolios. But with an eye on the long-term and in the interest of diversification, UK equities remain on the agenda for some investors.
The UK has defied widespread predictions of recession in 2023 but the outlook remains challenging
Large caps have consistently outperformed small and mid-caps since 2020, and performance this year has been helped by strong returns from energy and banking stocks.
If the UK does enter recession, funds such as WS Evenlode Income have the potential to outperform as a general decline for UK equities offers active managers the chance to demonstrate stock picking skill. This fund has a relatively concentrated portfolio and the top 10 positions account for 50% of the fund’s assets.
The fund has a fairly defensive positioning, with large international holdings in companies such as Reckitt Benckiser, Unilever and GSK, which have all been able to maintain profit margin and sales volumes despite rising inflation squeezing consumer spending.
Royal London Sustainable Leaders Trust should also perform relatively well in the case of recession. It has a similarly concentrated portfolio and its exposure to large-cap defensive companies should see it outperform the broad market.
The relative underperformance of the UK compared to other developed markets means many companies trade on lower valuations than international peers. This is particularly the case for mid-caps given their decline in 2022 and early 2023. Many investors are now convinced that the Bank of England has reached the end of the current rate tightening cycle, and this has spurred a sharp rebound in small and mid-cap stocks. This may not be sustainable in the short term, but data shows mid-caps often substantially outperform larger companies once central banks start cutting rates to stimulate growth.
Investors looking for exposure to mid and smaller companies that capitalise on potential gains from rate cuts in the UK have several options. Slater Growth and Unicorn UK Income offer exposure to quality UK small- and mid-cap firms and have been among the beneficiaries of the recent strong rally in this section of the market.
Meanwhile, TM Tellworth UK Smaller Companies and R&M UK Smaller Companies bring potential for more volatility, with a concentrated portfolio of smaller growth companies. If rates remain elevated, conditions will remain difficult for small- and mid-cap firms, but any easing of rates could significantly improve sentiment towards these stocks.
Charles Younes is deputy chief investment officer at FE Investments
