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UK equities: value opportunity or value trap?
Robert Lind
Rich Tennant
Equity Investment Analyst

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.

Implied equity risk premiums across Europe

Implied equity risk premiums across Europe

Data as at 31 July 2023. Source: ASR, Datastream

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.

Robert Lind is an economist with 36 years of industry experience. He holds a bachelor's degree in philosophy, politics and economics from Oxford University.

Rich Tennant is an equity investment analyst at Capital Group with research responsibility for European small- and mid-cap companies. He has 17 years of investment industry experience and has been with Capital Group for four years. Prior to joining Capital, Rich worked as a European small-cap portfolio manager at Fidelity International. He holds a master's degree in geography from Edinburgh University. He also holds the Investment Management Certificate. Rich is based in London.

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