UK Market Update

Recent developments have provided some encouragement for UK markets, although the response from investors has so far been measured.

The appointment of Prime Minister Andy Burnham and a Chancellor viewed as fiscally pragmatic appears to have reassured markets that policy is likely to remain disciplined. At a time when investors remain sensitive to government borrowing and fiscal credibility, continuity and restraint have been welcomed.

At the same time, inflation has once again come in lower than expected. June’s reading showed further signs that price pressures are moderating, supporting the view that UK interest rates could move lower over time. Government bonds and domestically focused equities responded positively, reflecting growing confidence that the inflation shock of recent years continues to fade.

However, the market reaction has been relatively muted.

Financial markets look forward, not backward, and much of this good news had already begun to be reflected in asset prices. Investors are now focused on the next stage of the story: whether inflation can continue to decline against a backdrop of renewed geopolitical uncertainty.

Recent tensions in the Middle East have pushed oil prices higher, raising the possibility that energy costs could re-emerge as an inflationary pressure later this year. As a result, while some bond managers have become more comfortable extending duration and positioning for faster or deeper Bank of England rate cuts, we are not yet convinced that the case is sufficiently clear-cut. The direction of travel for rates may ultimately be lower, but the path remains uncertain.

We are also monitoring the reaction in UK smaller companies. Historically, UK small-cap shares have benefited from falling interest rates and improving domestic confidence. Should investors become more confident that inflation is under control, and monetary policy is becoming more supportive, this area of the market may warrant greater attention.

Our overall view on UK equities remains neutral. While recent developments are encouraging, we continue to prefer seeking additional equity exposure through international markets, particularly emerging markets, where we see a broader opportunity set.

That said, UK equities continue to play an important role within diversified portfolios. The UK market has a very different sector composition from the US, with greater exposure to financials, energy, industrials and other economically sensitive businesses. This makes it a useful diversifier at a time when US equity performance remains heavily concentrated in a relatively small number of large technology companies.

Those companies have benefited significantly from falling bond yields and expectations of lower interest rates. Should inflation expectations re-accelerate, and government bond yields move higher again, some of the most richly valued areas of the US market could come under pressure. In that environment, the UK’s more balanced market structure may prove helpful from a diversification perspective.

Our view: Recent political and inflation news has been supportive for UK assets, but not sufficiently so to alter our positioning. We remain cautious on the outlook for interest rates, continue to monitor opportunities in UK small caps, and see value in maintaining UK equity exposure as a diversifier within globally invested portfolios.

The above information is for educational purposes and is not a personal recommendation or investment advice. Content is accurate at the time of writing. Tax limits may change in future. Capital at risk. Wise Investment is authorised and regulated by the Financial Conduct Authority (FCA 230553).