(The views expressed here are those of the author, an investment strategist at Panmure Liberum)

LONDON - The UK stock market has become one of the top contrarian trades after the recent Bank of America survey reported a record number of fund managers underweight the British market. There are plenty of reasons to think that UK equities could outperform their U.S. counterparts in 2026 and potentially for the next decade – and this optimism does not rest solely on Britain’s cheap valuations.

The typical bull case for UK stocks emphasises the market’s low relative cost. Using 12-month forward P/E-ratios, the FTSE 350 trades at a 42% discount to the S&P 500. This ignores the larger weight to tech stocks in the U.S., which distorts index valuations, but even if we adjust for differences in sector weights, the UK market still trades at a roughly 30% discount to the S&P 500. This is close to the largest discount in 30 years.

However, the potential for this valuation discount to narrow isn’t the only reason UK stocks could outperform in 2026 and beyond. Earnings growth is also poised to be higher on this side of the pond.

BUILDING BLOCKS

One of my favourite methodologies for forecasting earnings growth is the so-called ‘building block’ approach, in which sales growth is estimated based on the projected nominal GDP growth and inflation in the regions where companies sell their goods and services.

Companies in the FTSE 350, for example, generate 24% of their revenues in the U.S., 26% in the UK, 20% in Europe excluding the UK, and 30% in the rest of the world. Do the math, and this results in 4.6% estimated sales growth (real GDP growth plus inflation) in 2026 for the FTSE 350, compared to 4.4% for the S&P 500 and 4.2% for the Stoxx Europe.

We can then add the consensus estimates for margin expansion and share buybacks to arrive at an EPS growth estimate of 7.4% for the FTSE 350 versus 7.0% for the S&P 500 and 6.6% for the Stoxx Europe.

This means that even if the UK-U.S. equity valuation discount does not narrow, the UK market could still outperform by 0.4% or more in 2026. And that is before accounting for a 3.4% dividend yield in the UK compared with 1.2% in the U.S.

RISING PRODUCTIVITY GROWTH

It is not just corporate earnings that could grow faster in the UK than in the U.S. next year. Long-stalled productivity could pick up too.

The public discourse in the UK and the bear case for the country's equities typically focus on ‘broken Britain’, i.e., the country's weak productivity and ever-diminishing fiscal headroom. However, UK government investments in infrastructure, from nuclear power to artificial intelligence and transport, are ramping up – and that should be good news for UK productivity moving forward.

While current projections for UK productivity growth from the Office for Budget Responsibility (OBR) may be revised lower in the next UK budget announcement in November, productivity growth in the UK will still likely be expected to at least double in the next few years.

And when productivity growth accelerates, real wages and consumer spending tend to follow.

PASSING THE STRESS TEST

Factor in this expected boost to UK productivity and GDP growth, and we arrive at 10-year EPS growth estimates of 8.2% per year for the FTSE 350, compared to 5% to 6% for the S&P 500 and Stoxx Europe, respectively. True, these estimates might be too optimistic. Bureaucratic waste, over-regulation or sluggish job creation may all reduce the earnings lift.

But even if one stress tests these assumptions by reducing UK and European GDP growth forecasts or by making more optimistic assumptions for U.S. economic activity, it is challenging to find a realistic scenario in which U.S. corporate earnings growth is higher than the UK’s over the next decade. Even if the AI boom in the U.S. continues as expected, and I have my doubts about that, and none of that activity benefits the UK economy in the form of higher productivity growth, this would still likely not be enough to eliminate the expected UK earnings growth advantage.

The bottom line is that, if these projections are correct, then the UK stock market will offer stronger earnings growth and higher dividend yields than U.S. equities, and, on top of this, there is the possibility of multiple expansion and a reduction of the valuation discount versus the U.S.

Put this all together, and the UK bulls’ contrarian position starts to look pretty sensible.

(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank).

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(Writing by Joachim Klement; Editing by Anna Szymanski)