Capital Ideas^TM

Over the last couple of decades, UK equities have generated relatively low returns compared with US and eurozone markets — but could falling inflation and a global soft landing over the coming months trigger a recovery?

Since the Brexit vote, returns on UK small- and mid-cap stocks have been particularly weak and recent worries about inflation and interest rates have further undermined these domestically exposed stocks.

Price/earnings ratios suggest UK equities currently stand at a significant valuation discount to US and European peers. But we need to take a broader view of relative valuations to get a sense of whether the UK is offering such an opportunity or is actually more of a value trap.

Despite relatively weak gains in the UK market, the equity risk premium (expected return on equities less the expected return on bonds) has also fallen, reflecting the sharp rise in interest rates and potentially suggesting more limited value in UK shares.

Looking forward, however, a more benign environment for inflation and interest rates should boost the UK’s equity risk premium, which would restore the valuation discount. Lower inflation and interest rates would also reduce the risk of a deep UK recession, further supporting domestically exposed stocks.

Prospects for UK large caps and more internally exposed stocks will depend on whether the global environment changes in a similar way.