Following a torrid time recently, the outlook for the UK is turning more positive as we start 2025. The UK has suffered a rare, multi-year derating but its drivers have gradually dissolved, paving the way for a 2025 comeback which is already underway.
Valuation has twin drivers – the cost of capital and return on invested capital, both of which have suffered in recent years. Looking ahead, the UK is forecast to see continued interest rate cuts throughout the year leaving the bank rate at ~4% by the end of the year, we think. While forecast rate expectations have fallen from a peak of 6.5% in mid-2023, subsequent cuts were delayed throughout much of 2024. The first cut in August paved the way to a downward path in interest rates this year that should also feed through into a lower cost of capital next year.
Also falling is the UK’s political risk premium that reduced gradually over 2024 thanks to a reasonably centrist government with a clear majority. Greater political stability in the UK comes at a time when many European peers face messy and polarised political elections. This political stability should be thrown into the spotlight given the current chaos in Germany.
A combination of rate cuts and lower political risk premium should bring down the cost of capital, a prerequisite for the UK to rerate. There are risks, such as UK core inflation remaining elevated due to stubbornly high wage inflation which could temper rate cuts in at least the first half of this year. However, forward-looking indicators such as the Decision Maker Panel survey point to waning wage pressures. Even if wage inflation settles at c4%, above its pre-Covid trend, headline inflation could still only be 3% and necessitate rate cuts from here. The balance of probability suggests the UK will see a falling cost of capital, laying a much-needed foundation for a UK rerating.
Cheap P/Es, however, are meaningless if no one trusts the ‘E’ and sadly the UK has had disappointing earnings growth in recent years, at a time when the US has delivered growth well ahead of expectations. Having been at the bottom of the table, the UK is expected to be one of the fastest growing countries in the G7 in 2025. The key to this delivery is that the forecast UK income growth translates into spending growth rather than savings. The UK savings rate has been unusually high in recent years, but ONS data1 suggests around half of all excess savings are being used to reduce outstanding loans and debts. As the bank rate falls, this should naturally channel income growth back into income spending which should in turn be positive for GDP growth and, more crucially, domestic corporate earnings. With renewed confidence in the ‘E’, the groundwork should be set for the UK P/E to rerate.
We seek to expose ourselves to the double discount of cheap shares within a cheap UK market – but being cheap is not enough; you need to have improving returns on capital as well. As bottom-up, multi-cap value investors, we seek to capitalise on mispricing across the UK market-cap spectrum, investing in businesses that are not just cheap but also exhibit improving returns on invested capital and strong balance sheets. These lead us to be heavily invested in mid-cap stocks that are at a particular discount to their long-term valuation yet stand to benefit more from interest rate cuts, have high exposure to improving domestic earnings and are likely to continue to receive disproportionate M&A flow. Sectors with cheap valuations and improving fundamentals include non-life insurance, UK infrastructure, UK consumer exposure shares and UK REITs.
Following a torrid time recently, the outlook for the UK is turning more positive as we start 2025. The UK has suffered a rare, multi-year derating but its drivers have gradually dissolved, paving the way for a 2025 comeback which is already underway.
Valuation has twin drivers – the cost of capital and return on invested capital, both of which have suffered in recent years. Looking ahead, the UK is forecast to see continued interest rate cuts throughout the year leaving the bank rate at ~4% by the end of the year, we think. While forecast rate expectations have fallen from a peak of 6.5% in mid-2023, subsequent cuts were delayed throughout much of 2024. The first cut in August paved the way to a downward path in interest rates this year that should also feed through into a lower cost of capital next year.
Also falling is the UK’s political risk premium that reduced gradually over 2024 thanks to a reasonably centrist government with a clear majority. Greater political stability in the UK comes at a time when many European peers face messy and polarised political elections. This political stability should be thrown into the spotlight given the current chaos in Germany.
A combination of rate cuts and lower political risk premium should bring down the cost of capital, a prerequisite for the UK to rerate. There are risks, such as UK core inflation remaining elevated due to stubbornly high wage inflation which could temper rate cuts in at least the first half of this year. However, forward-looking indicators such as the Decision Maker Panel survey point to waning wage pressures. Even if wage inflation settles at c4%, above its pre-Covid trend, headline inflation could still only be 3% and necessitate rate cuts from here. The balance of probability suggests the UK will see a falling cost of capital, laying a much-needed foundation for a UK rerating.
Cheap P/Es, however, are meaningless if no one trusts the ‘E’ and sadly the UK has had disappointing earnings growth in recent years, at a time when the US has delivered growth well ahead of expectations. Having been at the bottom of the table, the UK is expected to be one of the fastest growing countries in the G7 in 2025. The key to this delivery is that the forecast UK income growth translates into spending growth rather than savings. The UK savings rate has been unusually high in recent years, but ONS data1 suggests around half of all excess savings are being used to reduce outstanding loans and debts. As the bank rate falls, this should naturally channel income growth back into income spending which should in turn be positive for GDP growth and, more crucially, domestic corporate earnings. With renewed confidence in the ‘E’, the groundwork should be set for the UK P/E to rerate.
We seek to expose ourselves to the double discount of cheap shares within a cheap UK market – but being cheap is not enough; you need to have improving returns on capital as well. As bottom-up, multi-cap value investors, we seek to capitalise on mispricing across the UK market-cap spectrum, investing in businesses that are not just cheap but also exhibit improving returns on invested capital and strong balance sheets. These lead us to be heavily invested in mid-cap stocks that are at a particular discount to their long-term valuation yet stand to benefit more from interest rate cuts, have high exposure to improving domestic earnings and are likely to continue to receive disproportionate M&A flow. Sectors with cheap valuations and improving fundamentals include non-life insurance, UK infrastructure, UK consumer exposure shares and UK REITs.
George joined Polar Capital in April 2017 to manage the Polar Capital UK Value Opportunities Fund with Georgina Hamilton. Prior to this, George managed the CF Miton UK Value Opportunities Fund and the Miton Undervalued Assets Fund at Miton Group.
Previously, George co-founded Matterley Asset Management in 2008 and was co-manager of the group’s Undervalued Assets Fund. Before founding Matterley, George was a Director of Equity Sales at Credit Suisse.
Georgina Hamilton, CFA
Georgina joined Polar Capital in October 2016 to set up the UK Value Team. Prior to this, she was with Miton Group where she managed the CF Miton UK Value Opportunities Fund and the Miton Undervalued Assets Fund.
Previously, Georgina was a lead analyst for the Undervalued Assets Fund at Matterley Asset Management. Georgina holds a double first in Biological Anthropology and Natural Sciences from Jesus College, Cambridge and is a CFA charterholder.
