UK equities: economic recovery gathers momentum

Key takeaways:

• UK economic conditions are in good health, supported by lower inflation, rate cuts, and a stable political environment.
• Strengthening consumer demand will be a major driver of UK economic strength.
• Domestically focused mid and small cap stocks are poised to gain significantly from the resurgence of the UK's economy.
   

The UK economy is gaining momentum

The UK economy is in solid shape. Data announced over the last few months has shown the economy to be gaining momentum, which bodes well for UK companies’ future growth prospects. In particular, the domestically focused mid and small cap companies are looking increasingly attractive amidst early signs of a consumer-driven economic recovery.

After a shallow recession at the end of 2023, the UK’s prospects have u-turned with recent economic results being surprisingly stronger than forecast. Improving UK growth can be seen in the recent,  better-than-expected recent Gross Domestic Product (GDP) numbers and upwards revisions to expectations for the next two years. Headline inflation is likely to remain close to 2% in the near term and easing price pressures are set to open the door to further rate cuts.

The Bank of England (BoE) has begun its rate cutting journey and this will be warmly welcomed by households and businesses where leverage is a feature. Given the rapid rise in interest rates over the past two years it’s important to appreciate that the extent of the impending cuts is likely to be limited. Returning to a period of ultra-low rates is out of the question, barring some significant external event. Market observers continue to expect UK rates to stabilise in 2026, likely in the 3-4% range¹. 

For those with mortgages, banks have already begun pricing in the upcoming rates cuts. The 5-year Sterling Overnight Index Average (SONIA)* swap rate, used by UK lenders to price loans, dropped to 3.8% in July². As mortgage repayments represent many households’ largest outgoings, these reduced costs will be extremely welcome. Increasing mortgage affordability is also supportive of a strong property market, one that held up reasonably well as rates rose. Little wonder the GfK Consumer Confidence Index† is at 2-year high³.

The UK is a consumer economy, and improvements here will be the driving force in Britain's recovery. Consumer spending represents over 60% of GDP⁴ and increasing confidence will be supportive of growth. Challenges remain, the consumer is not one homogeneous, carefree group that’s ready to spend with the cost-of-living crisis not over for many. However, an increasing proportion of the population is now entering a period of real wage growth, with salary increases outstripping inflation. Moreover, in April 2024, a c.10% increase in the National Living Wage and a 4%⁵ cut to National Insurance were implemented. UK living standards, in aggregate, look to be on a positive trajectory.

What does a Labour government mean for the economy?

Labour appears to have timed their ascent to power well. It’s perhaps not quite as positive a backdrop as Tony Blair entered Number 10 to in 1997, but the current nascent economic recovery is a reasonable starting point for the new government to inherit. A stable government reduces medium term political risk but Labour’s stated commitment to fiscal prudence, not wanting a repeat of Liz Truss's mini budget debacle, means the UK’s near-term outlook won’t be drastically altered.

Investors will be closely scrutinising the new governments’ ‘Growth Plan’ as the new UK Chancellor Rachel Reeves has announced a series of measures to unlock GDP growth. Early announcements show a significant focus on planning reform and investment to get Britain building again.

This won’t happen overnight, and many are sceptical their house building targets will never be reached. However, there is already evidence of a rebound in the construction sector with recent figures showing construction grew at the fastest rate in almost a year in May, with house building and infrastructure boosting the industry.

So far, the market has reacted positively to the Labour victory as can be seen by the strength of sterling versus the dollar and euro. With UK growth having strengthened, sterling has jumped to its highest level against the dollar in almost a year. Sterling strength also has the effect of bearing down on inflation. All this bodes well for the more economically sensitive and domestically focused UK mid and small cap companies.

We are only at the foothills of the opportunity. Early-stage shoots of growth, inflation at target, rates cuts; all coupled with UK valuations at historic discounts. The stars are aligning for the UK – it’s time for UK mid and small cap to reassert their leadership.