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As the economy improves and Carney guides on interest rates, we look at five ways to play the UK recovery

A slew of recent data suggests that a recovery in the UK economy is gathering pace. Positive signs include a rapid acceleration of activity in the UK service sector, improved manufacturing, construction and retail data, a pick-up in car sales and rising house prices buoyed by the Funding for Lending and Help to Buy schemes. Confidence in the recovery is growing and gained an additional boost today with the new Governor of the Bank of England, Mark Carney, announcing that interest rates will remain at current ultra-low levels until unemployment falls below 7%. Unemployment is currently at 7.8% and the Bank of England expects it to remain at around 7.3% for the next three years. This should help reduce uncertainty.

So how can investors play the UK domestic recovery?

For investors wanting to play the UK recovery theme, it is important to not lose sight of the fact that the link between the UK stock market and the domestic economy is only partial given the international earnings profile of companies listed on the London Stock Exchange. In fact some two thirds of FTSE 100 company revenues are earned outside of the UK.

For greater domestic exposure, investors need to fish further down the market cap spectrum. Five ideas for investors identified by our research team are:

  1. AXA Framlington UK Mid Cap (4 star rating) – in contrast to the international earnings make-up of the FTSE 100, the FTSE Mid 250 Index earns around half its revenues at home so has more domestic characteristics. This fund, managed by Chris St. John, is a relative minnow at circa £17 million, which we see as an advantage when focusing on a relatively narrow universe of stocks. At least 70% of the fund invests in the FTSE Mid 250 but it can invest up to 15% in FTSE 100 companies, with the balance in smaller companies. Large holdings include the likes of equipment rental firm Ashtead group, property search engine Rightmove and building supplies firm Travis Perkins.
  2. Old Mutual UK Smaller Companies fund (4 star rating) - The Old Mutual UK Smaller Companies fund is typically 40% invested in mid-caps and 60% in smaller companies and currently has a cyclical bias. Some 35% of the portfolio is invested in industrials and 17% in consumer services. Key holdings include Ashtead Group, brewer Greene King, fund manager Jupiter and property groups Bellway, Galliford Try and Barratt Developments.
  3. Unicorn UK Income (4 star rating) – managed by veteran small-cap investor John McLure this fund is 90% invested in smaller companies (10% in mid-caps) with a focus on companies that generate a decent level of dividend. The portfolio is therefore very different from a typical income fund, with large holdings including cinema chain Cineworld, express delivery firm UK Mail Group and wealth manager Brewin Dolphin. For hard pressed income seekers, this could make an attractive foil to a traditional equity-income fund.
  4. Henderson UK Property (4 star rating) - Commercial property has a close correlation with the health of the economy and in recent years has seen some tough times, especially funds with exposure to the UK high street because 2012 saw a record number of high street chains hit the buffers (think Jessops, HMV) leaving properties vacant. A weak economy limits the scope for rent rises as well. A sustainable recovery would support property valuations and yields but one nagging concern is refinancing risk: property deals done at the height of the credit boom not being refinanced on such generous terms as banks toughen up. We therefore think it makes sense to focus on property funds focused on high quality locations. We like Henderson UK Property which is currently yielding 4.3%.
    Venture Capital Trusts – VCTs are restricted to investing in small, UK unquoted or AIM-traded businesses so fish very directly in the UK pond. With bank financing remaining constrained we believe VCTs are in a good position to attract new deals from companies looking for the funds to help grow their businesses. Importantly, improved economic sentiment could create a more amenable environment for mature VCT portfolios to achieve successful exits on businesses they invested in prior to the credit crisis. An increase in successful exits from mature VCTs would pave the way for rising tax-free special dividends. Several VCTs are fund raising at the moment but it is important for investors to understand the risks and restrictions before investing. For higher rate tax payers who are already maxing out on their annual ISA and pensions allowances, VCTs can be a useful add-on. For more information visit our VCT centre.

Finally, while the good economic news should put a spring in the step of investors, it is clear that parts of the UK equity market have priced in a lot of this optimism.

However, across the globe markets are likely to remain skittish as investors try to assess the extent of the slowdown in China and the potential impact on global growth, as well as the timetable a potential tapering down of QE in the US.

Investors should therefore apply a common sense approach of phased investing or buying on any dips, rather than piling in blindly on the back of exuberant data.

This article does not constitute a personal recommendation or advice to switch investments. If you are in doubt as to the suitability of an investment please contact one of our advisers. Please note that historical or current yields should not be considered reliable indicators of future performance. Funds may carry different levels of risk depending on the industry sector(s) in which they invest. You should ensure that you understand the nature of these risks before purchasing a particular fund. Smaller companies’ shares can be more volatile and less liquid than those issued by larger companies, so funds investing mainly in smaller companies can carry more risk. The property market can be illiquid; consequently, there can be times when investors will be unable to sell their holdings. Property valuations are subjective and a matter of judgement. The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested.