Sterling is on the rise again as investors regain optimism there’ll be a Brexit deal. Could another leg up in the currency following a firm accord spur interest in the unloved UK equity market? Being cheap may at last be sufficient reason for investors to buy.
Anecdotally, global asset managers gave up on UK shares after the Brexit referendum. But their general aversion to the London market goes back further. Since the financial crisis, there’s been a dash for stocks that promise some kind of growth in a low-growth world. That has favored the US S&P 500 and its tech giants, not the FTSE-100 with its focus on oil producers, miners, and banks.
The tables may be turning. A Brexit agreement, if it happens, would remove the risk of a chaotic exit from Europe. And it would come just as the macroeconomic context is moving in favor of the composition of the UK equity market: Economists are looking forward to a period of expansion driven by stimulus and a gradual end to the pandemic. That environment diminishes the scarcity value of growth stocks and the safety value of defensive stocks. It favors the FTSE-100’s emphasis on so-called cyclicals whose fortunes track the broader economy.
Morgan Stanley analysts last month identified the UK as the world's cheapest region on a range of metrics. Small wonder then that UK equities have outperformed US and European benchmarks since early November. The FTSE-100’s valuation as a multiple of earnings in the next 12 months is still low relative to other indices, at a roughly 15% discount to the Bloomberg European 500 index, and 30% to the S&P.
The snag is the UK index’s relationship with sterling. Some 70% of its constituents’ sales are international, according to analysts at Goldman Sachs Group Inc. If the British currency is now set to gain on the back of a deal, that would hold back profits reported in pounds. Investors would need to believe that economic growth pushing the index higher will be a more powerful force than the drag of a strengthening currency.
Such considerations might prompt investors to seek stocks offering exposure to the U.K. itself. The country’s economy has suffered a particularly sharp drop in Europe during the pandemic, largely due to its reliance on the services and consumer sectors. If vaccinations help ease lockdown restrictions, unleashing consumer spending, the rebound could be especially strong.
The FTSE-250 index of mid-sized stocks is usually seen as a better play on the UK than the FTSE-100. Goldman’s analysts point out that the benchmark is positively correlated with sterling, its composition being more evenly split between domestic and international businesses. But it’s an imperfect way of riding a UK turnaround. The FTSE-250 is a mishmash, including stocks that have fallen out of the FTSE-100 because they’re struggling. It’s not obviously cheap either, trading on a similar valuation to the European market (although this may reflect expectations for upward earnings revisions).
A more specialist index or careful stock-picking would provide more focused exposure to a UK recovery. Paul Marshall, co-founder of hedge fund Marshall Wace, recently told the Financial Times he was finding “lots of pockets” of value in the U.K. Just over 100 members of the FTSE-350 (the two main indices merged) get more than two-thirds of their sales domestically, according to Bloomberg data.
Assume that within this group, the sectors most exposed to the broader global “reflation” theme — such as financials, housebuilders, capital goods, and media — are the most interesting. That subset has a low forward price-earnings multiple of just under 14, taking the average based on forecasts compiled by Bloomberg. No surprises there: These are stocks in both a country and sectors that investors have been averse to for years.
There’s still no Brexit deal of course. And even if it comes, investors should remember one sobering thought. The UK market has looked cheap for years, yet it has repeatedly disappointed.
(Bloomberg)
