Why it’s not too late to play the UK’s economic recovery

But investors must be ultra-selective to see any long-term gains

AFTER two scintillating years for British equities, which saw shares boom alongside a surprisingly strong economic recovery, many UK-focused stocks have come off the boil. The mid-cap FTSE 250 (whose constituents draw over half of their sales from Britain) is down almost 0.6 per cent since the turn of the year, following a 26 per cent gain in 2013. The Aim All-Share index, meanwhile, has fallen from over 890 at the beginning of March to around 813 yesterday.

Much of the positive economic news is arguably priced in by now. And a growing number of fund managers think that the link between rising economic sentiment and UK stocks has broken down, with corporate earnings taking over as the main driver of returns. As Peter Sleep of Seven Investment Management puts it, “there are people out there who think the green shoots of recovery have turned into green mould for investors.”

While this makes playing the UK’s ongoing economic recovery more difficult, it’s not time to give up hope. Valuations are no longer in the “bargain basement category”, says JP Morgan Asset Management’s William Meadon, but opportunities exist for investors prepared to look beyond the short term. Stocks in “late cycle” sectors and select areas of the property market likely still have room to run, while adventurous investors should look at accessing small, unlisted firms through venture capital trusts (VCTs).

But first, why are fund managers feeling less cheerful about the UK recovery play? A return to growth has seen small and mid-cap stocks surge in the last few years. With yesterday’s GDP release showing that year-on-year growth stood at 3.1 per cent in the first quarter, why will UK-focused stocks not continue to soar across the board? “Small and mid-cap stocks have been key beneficiaries of recovery fever, especially highly cyclical sub-sectors such as house builders,” says Jason Hollands of Bestinvest. “But valuations now look pretty stretched in some of these areas – an awful lot of optimism is priced in.” With “recovery fever” fading, some argue, it’s no longer a case of a rising tide lifting all boats. Investors will need to exercise increasing discrimination to avoid hitting the various speed bumps likely to appear. And there could be plenty.

Credit Suisse equity analysts recently put out a note arguing that this could be “as good as it gets” for domestic UK plays. They cited high equity valuations, political uncertainty (a Labour general election victory, or Scottish independence), and the risk of an earlier-than-expected rate hike (before March 2015) as some of the chief reasons. The winding down of QE by the US Federal Reserve, which caused the “taper tantrum” in equity markets last year, could be a sign of things to come when the Bank of England hikes rates. Moreover, Hollands argues, ultra-loose monetary policy and support for the property market in the UK have led consumers to “rack up their personal debt levels”, making the UK economy very vulnerable to a shock from rate rises.

For these reasons, many now see Europe as a source of more attractive opportunities than the UK. The European Central Bank (ECB) is considerably further away from hiking rates than the Bank of England, and is expected to introduce further easing to combat disinflation at some point. The IMA European Smaller Companies fund sector, moreover, has caught up with the UK Smaller Companies sector, returning 3.29 per cent since the start of 2014, compared to 1.99 per cent for the UK equivalent (see chart). Hollands says that the differing trajectories of the Bank and ECB could cause this gap to widen.

But this is not to say that selective investors can’t gain from a continuation of the UK recovery. Hargreaves Lansdown’s head of research Mark Dampier argues that fears over the decline of UK small and mid-caps can easily be overstated. “The FTSE 250 is refreshed a lot more than some other indices, and the fact that these stocks tend to be less researched than blue chips means that there are often deals to be found.” Some funds at the top of the IMA UK Smaller Companies sector have managed to maintain strong growth in 2014 (see chart). And Sleep argues that uncertainty over corporate earnings, which he says has led many UK stocks to fall out of favour recently, can easily reverse with rising economic growth. He recommends the Dimensional UK Core Equity fund, which has risen by 27.6 per cent over the past three years, as a good way to gain exposure to these out of favour stocks.

The authors of the Credit Suisse research, meanwhile, point out that “late-cycle” stocks are likely to benefit as the recovery continues, including employment agencies like Hays and Michael Page. And Hollands argues that, given its close correlation to the domestic economy, commercial property is another sector that could do well from a continuation of the recovery. Caution is advised, given widespread warnings of a frothy property market, but Hollands expects returns of around 12 per cent in the sector this year, as occupancy rates improve. The Henderson UK Property fund has a good exposure to office space, and many brokers have recently affirmed a “buy” rating on estate agents like Foxtons.

For more adventurous investors, another way to gain exposure to potentially fast-growing UK firms is to dig deeper into the small-cap sector through VCTs. These trusts are high-risk, but with UK corporate lending still relatively constrained, Dampier says that VCT funding rounds have been buoyant this year, and could offer attractive long-term returns. A number of VCTs close their offerings soon (Mobeus’s Linked Offer shuts tonight), but others stay open into the summer, including the Puma VCT 10.