It has become fashionable to paint a miasmic picture of the British economy. National newspapers churn out downbeat headlines, and the government – elected just over a year ago – is already underwater in the polls, with 62% of the public saying the country is headed in the wrong direction.

This gloom has spilled into investment decisions. Domestic investors are underweight UK assets compared to their peers in other Western markets. Only 4.4% of UK pension assets are currently invested in UK stocks – dramatically below the global average of 10.1%, and far lower than the 39% allocation recorded in 2000.

As George Orwell observed, the English are not happy unless they are miserable – a habit now shaping investor sentiment. And it’s become such received wisdom that it no longer reflects reality. A mix of underlying growth, specific opportunities, and market discounts means Britain still offers serious promise for investors. The scale of investor pullback means there are greater prospects for investors willing to give the country another look.

There’s a very real case for investors interested in taking another look at UK equities, but the degree of pessimism espoused by UK investors has arguably become excessive. There are many positive drivers that could reverse the negative sentiment towards the UK. Once it improves, share prices could go into recovery mode, offering investors the potential for significant upside from the current depressed levels.

Level setting: A more accurate macro backdrop

Setting a proper, balanced economic picture starts with baseline statistics about the British economy. The government has correctly boasted that the UK had the fastest-growing economy in the G7 for the first half of this year. The economy grew by 0.7% in the first quarter. In the second quarter growth slowed to 0.3%, but that was better than Germany, Italy and Japan – who all shrank – and a flat Canada.

Look deeper and there is further room for optimism: GDP per head, which many people would regard as the key measure, rose by 0.8% in real terms in the first half of the year and at the end of the second quarter was 0.7% up on a year earlier. This compares to an annual reduction of 0.5 per year in the last parliament and shows the country is not simply growing because of population increases.

Independent economic forecasters still show relative outperformance for the rest of the year. The International Monetary Fund (IMF) update raised the UK’s growth outlook for the year and said it would be the third strongest of G7 economies. This is no longer simply repairing Covid-era damage: the country’s GDP is now 2.2% above its pre-pandemic peak, another upward revision.

While hardly the lead story in the evening paper, a deep review of the numbers shows an economy headed forward, not backwards. In his comprehensive review of the macroeconomic picture, Reuters columnist Joachim Klement concluded that:

“ultimately, the UK economy appears to be doing just fine, and most leading indicators point to a continued recovery of GDP growth in the second half of this year."

Policy risks and catalysts

One layer below the overall macroeconomic picture is the impact of government policy. Upon entering office, Chancellor Rachel Reeves confirmed her commitment to a set of fiscal rules. These include debt as a share of GDP, ensuring day-to-day spending is funded through taxation rather than borrowing, and limiting investment spending to projects that can demonstrate long-term productivity gains. A reaction to the disastrous budget proposed by Kwasi Kwarteng, which proposed tax cuts funded by debt. The rules are designed to assure the markets of the administration’s commitment to fiscal discipline.

The question is whether these rules ultimately facilitate or hinder growth. The IMF broached the idea of changing these rules, saying that current policy made the “government vulnerable to small economic changes, which can erode fiscal headroom quickly”. Backbenchers in the current government expressed similar sentiment in an anonymous gripe to The Guardian, “This is driving our constituents into poverty and destroying faith in a Labour government to make tiny numbers on a balance sheet add up.” As of now there’s been no change, with the Treasury continually confirming its “ironclad” commitment to current rules.

Filling the fiscal hole

The consequential decisions around the direction of fiscal policy will all be made around the Autumn Budget, the year’s largest monetary event. Despite promising that tax rises last year were a one-time event, lower than expected tax revenue, combined with failure to introduce welfare spending cuts, mean the government will need to fill a fiscal hole of c.£50 bn just to maintain current policy. Current speculation (and there is much speculation) is that the Chancellor will be forced to raise revenue through new taxes or further spending cuts.

Sources with various levels of connection to the government have floated a variety of possible solutions in the past two months, including everything from a wealth tax to a property tax or increase on income tax for the wealthy. The exact route will be very consequential to the markets, as observers will be looking for a way to maintain fiscal stability while not smothering consumer spending or growth. Thirty-year bond yields have climbed to their highest levels in four decades, trading well above those in EU economies – a clear signal of investor uncertainty.

Are we heading towards an IMF bailout?

In the long gap between the summer and concrete government policy in the late autumn, Fleet Street has been trying to whip up a frenzy. The Sunday Telegraph and Daily Mail ran near identical headlines on Britain’s march towards an IMF bailout. Neil Shearing, Chief Economist at Capital Economics, provided some much needed perspective in a note to clients:

"The IMF is not called into countries that can finance themselves in their own currency and retain the confidence of investors... Britain, for all its shortcomings, is not in this category."

Industry groups have long pushed for a simpler regime, arguing that the current patchwork of Cash, Stocks and Shares, Lifetime, and Innovative Finance ISAs is confusing for savers and leads to underutilisation. A merger into a single “One ISA” has been mooted, which would allow investors to move seamlessly between cash and equity holdings. Another option is raising the annual contribution limit – currently £20,000 – which has not changed since 2017 despite inflation. An idea that would be particularly useful in boosting investment would be “British ISA” wrappers for domestic shares, which was announced in 2024 but later abandoned.

For the government, the attraction is twofold: a more straightforward savings vehicle that supports its mission of mobilising retail capital into productive investment, and a reform that is relatively low-cost to the Exchequer compared with direct spending. For investors, any expansion in the scope or attractiveness of ISAs could deliver a surge of new flows into funds and securities, providing some counterweight to a sluggish institutional market.

Market positioning & small-cap opportunity

Against this backdrop, the more interesting story is in small- and mid-caps – attractive both for their present valuations and their future upside. At just 10-11x earnings, the FTSE 250 trades well below its long-term average of roughly 16x, and far beneath U.S. benchmarks, where seven-year average P/Es have hovered near 24.5x. Forward earnings multiples tell the same story: the FTSE 250 sits around 13.5x, compared with 17.6x for the MSCI Europe Small Cap Index and roughly 14.2x for European small caps as a whole. In relative and absolute terms, UK small caps are cheap.

That discount reflects not weak company fundamentals but a generational retreat in domestic demand. From around a quarter of global equity benchmarks in the late 1980s, the UK’s weighting has shrunk by more than 80%. Pension funds and insurers have followed the same path: once holding over half their assets in domestic equities, they now commit less than 4%. This structural under-ownership leaves many companies overlooked and mispriced, regardless of the strength of their business models or balance sheets.

The result is  a “double-discount”: regional stigma and sector underweights converging to depress valuations. Global investors increasingly treat the UK as peripheral, while local institutions continue to cut exposure. Yet this ignores the real opportunity in what  analysis has found were the “most unloved stocks in the world”. Not every small-cap company will be able to navigate the current headwinds around demand, costs and technology, but some will. And growth is not a prerequisite: dividend yields and buybacks could deliver ~10% returns even in a flat growth environment – especially considering record buyback levels.

Opportunity in practice

Here are two examples of undervalued UK companies that represent exciting investment opportunities.

With the “Super Sewer” Thames Tideway Tunnel now complete, the industry is shifting into its next phase of capital investment. Asset Management Period 8 (AMP8) – the regulatory cycle running through 2030 – will see regulator Ofwat oversee a record nearly £100bn of spending, the largest programme in the sector’s history. Contractors and service providers positioned to capture this capex wave are set to benefit, even as the utilities face political heat over bills, sewage outflows and dividends. This is mandated spending for environmental upgrades, wastewater treatment, and resilience projects.

Galliford Try stands out as one of the best-placed beneficiaries from this windfall. The UK construction and infrastructure group has deep expertise in regulated markets such as water and environmental works, and unlike peers tied to commercial property cycles, its revenues are anchored in long-term public programmes. Its strengthened balance sheet and record order book put it in a strong position to secure a disproportionate share of AMP8 contracts. For investors, that combination of exposure, stability and financial resilience makes Galliford Try a direct play on the coming infrastructure boom.

JTC, a Jersey-based fund and corporate services firm specialising in outsourced administration for private equity, real estate, and institutional investors, is riding a powerful structural wave. The demand behind its growth is straightforward: cost-efficient, professional back-office operations have become a must-have. As family offices proliferate globally – Jersey now serves as custodian to around £1.3 trillion of wealth – their appetite for third-party administration has surged. A 2023 survey by Ocorian found that 91% of family offices expect to increase outsourcing of key services over the next three years, and 28% anticipate dramatic increases.

The attraction is clear: a business model built on recurring revenues, high client stickiness, and rising demand from family offices and institutions alike. With outsourcing now a firmly established practice for family offices, the firm is positioned to deliver resilient, long-term growth in a niche but expanding market.

Downing’s funds are positioned to capture this upside

For investors convinced by this case, the challenge is finding companies with resilient models that can deliver returns in an under-owned market. That requires a granular understanding of UK small- and mid-caps and the ability to distinguish between cyclical headwinds and long-term value.

That is the focus of VT Downing Small & Mid-Cap Income Fund. Its quality-value approach seeks out businesses overlooked by the market or underappreciated for their ability to compound earnings growth and dividends over time. By targeting firms with strong balance sheets, recurring cash flows, and capacity for shareholder distributions, the fund aims to capture the very mispricing that has left the UK among the cheapest developed markets.

For all the pessimism, the UK offers one of the most undervalued opportunities in developed markets. Investors willing to look through the gloom could be well rewarded.

“UK small and mid-caps remain one of the most overlooked corners of global markets but therein lies the opportunity. Valuations are compelling, fundamentals are strong, and for those willing to look again, the upside could be significant.” Josh McCathie.

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This article is written by:

Josh McCathie

Fund Manager

Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice.

Important notice: this document has been prepared for professional investors and has been approved as a financial promotion by Downing LLP (“Downing”). Capital is at risk and investors should note that their investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 10 Lower Thames Street London EC3R 6AF.

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