The future is bright… but it will be a bumpy ride

The UK economy has been in the news for the wrong reasons in recent weeks. UK growth has petered out after a promising start to 2024 and rising government bond yields have provoked comparisons with Liz Truss’s disastrous mini budget in 2022.

There is no doubt that the outlook for the UK has deteriorated. We are still waiting for all the data, but it looks like GDP growth will come in at zero over the second half of 2024, much weaker than many initially thought. We do expect a minor recovery to 1% growth in 2025, however this is well below the forecasts of the Bank of England and the OBR. The drivers of this growth are likely to remain the same: better consumption due to improving real disposable income growth and an expected drawdown of elevated excess savings. A lower Bank of England base rate may also help to reinvigorate capex and housing investment, but there’s likely a low ceiling to any recovery given the ongoing weak sentiment.

Similarly, the labour market is also worsening. Multiple surveys indicate employment is declining and we expect this to continue in 2025 as layoffs increase in response to compressed margins amid weak demand and National Insurance tax increases.

UK’s positive start to 2024 fizzles out

Citi Economic Surprise indices

Source: LSEG Datastream, Fidelity International, February 2025

Inflation remains relatively high, despite a welcome downside surprise in December. However, VAT on private school fees and energy price rises will likely maintain upwards pressure on inflation for the time being.

Finally, the UK’s fiscal situation, while not as bad as the mini budget debacle of 2022, also looks unenviable. Last year’s budget proved more expansionary than expected, featuring higher spending, taxes, and borrowing. Government debt is forecast to rise over the coming years, and meeting the fiscal rule of falling debt by the end of the current parliament relies on optimistic growth assumptions (2% for 2025 and above 1.5% throughout the forecast horizon).

Many have pointed to the UK’s twin deficit dynamics (fiscal and current account) as an area for concern, which makes it more sensitive to global interest rates. Indeed, the recent rise in yields has essentially eliminated the government’s fiscal headroom due to rising borrowing costs.

Yields on UK Gilts are attractive

Given the poor macro backdrop, we believe UK government bonds present an attractive proposition, and we have been adding to our Gilts position for the last few months. The recent rise in yields was largely caused by global rates moves rather than a significant reappraisal of the UK’s fiscal situation and presents investors with an attractive entry point. The yield on 10-year Gilts now sits at around 4.6%, similar to that of US Treasuries. However, the UK has a notably worse growth and labour market outlook than the US. Markets are pricing in around three rate cuts from the BOE this year and we believe the eventual total could be more than that, which would be an additional tailwind for Gilts.

UK equities offer stock picking opportunities

Our outlook for UK equities is more mixed. The UK macro environment is not encouraging. However, there are a few silver linings: valuations remain attractive, the BOE cutting rates should help growth, and the UK is relatively insulated from the threat of US tariffs. We had been overweight in the first part of 2024 in reflection of the brighter economic news at the time, but the 2024 autumn budget was not as pro-growth as we had hoped, causing us to reduce our position to neutral overall.

However, we have identified two UK active managers that we believe have excellent potential to add alpha through stock selection. As such, we have positions in UK equity funds from both Artemis and Polar Capital as well as a short position in the FTSE 250 index. This reduces our exposure to UK equity market movements while the outlook is poor while retaining our ability to capture alpha from managers that we believe will perform strongly.

We like the distinct investment process that the portfolio managers follow at Polar Capital. Their clear philosophy and investing discipline ensure consistency in the types of company they select. We believe the fund is a good option for active small-and mid-cap UK equity exposure. Meanwhile, the Artemis UK Select fund is a concentrated multi-cap best ideas fund run by experienced portfolio manager Ed Legget, who has an exceptional track record of managing UK equity portfolios. Despite returning c.50% over the last 2 years, the fund still trades at a discount to the market. This indicates that the fund could offer downside protection versus the broader UK market if sentiment were to sour and could even experience stronger returns if sentiment improves and multiples expand.

We will continue to monitor the UK for changes to the macroeconomic backdrop and search for the best top-down and bottom-up opportunities to add alpha.

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