Despite the doom and gloom of recent years the outlook for UK smaller companies is starting to finally look more positive.

Recently released revised UK GDP figures from the Office for National Statistics (ONS) showed by the end of 2021 the UK economy was 0.6% larger than prior to the pandemic. Previously the figures had shown that the UK economy was 1.2% smaller.

This positive news about the robustness of the UK economy has been well received and has affirmed what we have observed and heard from the companies we speak to. 

The economy continues to successfully stave off recession and inflation is gradually falling. We have held the view for some time that UK inflation data would continue to fall on the back of lower gas and soft commodity prices compared with a year ago but the increases in interest rates are also now starting to take effect.

The value within the UK smaller companies market is very apparent to us. Whether we compare current valuations to history, or to other international markets, the sector looks anomalously cheap.

Our prevailing view this year has been that the market was pricing in a worse recession than was likely, if at all. We have seen this play out in 2023 so far as growth estimates had been revised upwards even before the revised figures from the ONS.

Whilst the economic backdrop is still somewhat underwhelming, we continue to see opportunities to buy undervalued shares in companies with excellent long-term growth potential.

 

Unwarranted negativity

Inflation and the response of central banks has been a significant influence on markets so far this year. Interest rates now stand at 5.25% after 14 consecutive rises but it would appear that we are approaching the peak of this cycle.

Whilst the focus has been on the increased cost of borrowing, in aggregate, we believe the benefits from higher interest on savings outweighs the negative impact on mortgages. Contrary to popular thinking, the increase in interest rates may even be beneficial to the overall level of consumer spending. With that in mind, it seems less likely that the UK will have a recession this year and, if it does, it is likely to be mild.

Another key feature of the markets in recent months has been the outbreak of artificial intelligence (AI) mania. Although AI has been around in various forms for years, the accessibility and human sounding output of ChatGPT has captured the imagination of investors.

Investment banks looked to capitalise on this trend by creating trading baskets of stocks that might be negatively impacted by AI and unfortunately some UK smaller companies have been caught up in this and fallen substantially.

While we believe that AI will continue to develop and could be an important driver of productivity, it is unclear to us why it would be negative for many of the affected stocks and, as a result, we used the opportunity to add to some of our own holdings.

Undervalued UK

Having gone nowhere for the past five years, the UK equity market looks cheap, relative both to its own history and other global markets. At some point this is likely to be recognised by international investors and we will see a reweighting back towards the UK, which will be beneficial for the UK market overall.

In the absence of this, we’ve seen a pickup in the number of takeover bids, both from corporate and private equity buyers, looking to take advantage of the low valuations. Overall, this should be helpful for market levels.

 

Brighter times ahead

We believe that inflation should continue to fall as we move through the second half of the year. The European wholesale gas price has fallen by about 75% year-on-year and we’ve also seen soft commodities, such as wheat, decline over the same time period. Our conversations with companies also suggest they are seeing a moderation in their costs.

Meanwhile, after significant disruption following the pandemic, supply chains for items such as semiconductors are now functioning normally again. The cost of shipping goods around the world has also fallen significantly.

Staff availability, which was a major problem for businesses last year, has also started to improve. This has begun to feed through to wage settlements, suggesting that companies won’t need to raise prices as much over the coming year.

Over time this should begin to feed through to the overall rate of inflation and lead to an improvement in household living standards. For these reasons, we believe we are near the end of the current interest rate cycle and, as we have seen in the US, this should be received positively by markets.

 

Fully invested

We are increasingly confident in the outlook for UK smaller companies and have moved to being fully invested, with the potential to add gearing. We increased our cyclical exposure as stock markets fell and are well placed to take advantage of an improvement in the broader economic environment in the UK.

Investors can capitalise on a revival in UK smaller companies by holding a blend of quality companies trading at reasonable valuations with visible earnings growth and cyclical names that are trading at cheap valuations, but which have scope for a rerating.

We believe sentiment could turn quickly if the market gains confidence that inflation is on a sustained downward trajectory and interest rates are about to peak. Investors should be primed for this opportunity.

Jonathan Brown is manager of the Invesco Perpetual UK Smaller Companies Investment Trust. The views expressed above should not be taken as investment advice.