Why UK equities could stage a recovery in the year Brexit (finally) happens
17 January 2020
A strong cocktail of political and economic uncertainty has led to a period of sustained underperformance from the UK relative to other global equity markets. But as signs of a recovery emerge, we outline why the year of Brexit could coincide with an unusually strong year for UK equities.
- UK equities look well placed to deliver strong performance relative to other major equity market regions in 2020.
- Boris Johnson’s victory reshapes the political landscape and more certainty could boost sentiment from businesses, consumers and global asset allocators alike.
- A contrarian approach that can reach down the market cap spectrum looks best placed to access some of the most promising UK investment opportunities.
" If you are going through hell, keep going."
After what has seemed like an interminable period of underperformance, UK equities are finally showing signs of recovery and now look well placed for strong future performance relative to other regions. The event that investors have fretted about since 2016 could coincide with an unusually strong year in relative performance for the UK. While this might seem counter-intuitive, the market often finds a way to confound expectations.
Pre-Brexit referendum, the UK was seen by global investors as a politically stable and relatively business-friendly place. Subsequently, the UK government failed to articulate a clear vision for how to leave, and what comes after leaving. In parallel, a hard-left (by recent British standards) opposition Labour Party emerged, promising tax hikes and nationalisation. Such a cocktail of political uncertainty and seemingly anti-business sentiment left asset allocators, corporations and to some extent, consumers, with little incentive to invest in the UK economy or in UK stocks.
The old cliché that ‘the market hates uncertainty’ rang true over this period, producing a meaningful underperformance of UK equities compared to other regions.
UK equities have lagged every other region
Past performance is not a guide to the future.
Source: Fidelity International, Datastream, as at 31 December 2019. Based on total return in GBP.
December’s decisive Conservative party victory reshapes the UK political landscape. For the next 5 years at least, we can expect relative stability in the UK political environment, just as the US is gearing up for another divisive Presidential election, in which Bernie Sanders is polling well and leading the all-important campaign finance race for the Democrats.
In a world of expensive assets, the UK looks relatively cheap
After years of underperformance, and lofty valuation multiples in other markets, the UK now looks cheap on a relative basis. While the UK typically trades at a discount to the high growth US market, the differential today is historically unusual. A more benign macroeconomic backdrop, as well as a changing political narrative, in both the UK and US could drive a narrowing of the valuation discount.
The UK is at a discount to its long-term P/E ratio, unlike other developed markets
…and is particularly appealing to income-seekers
Source: Fidelity International, Refinitv Datastream, as at 31 December 2019.
What could drive superior relative performance of the UK?
A confident consumer: A recent research meeting with one of the UK’s largest estate agents highlighted very positive market conditions post-election, and a significant improvement in buyer sentiment. With real wage growth of c2%, a strong employment backdrop, and declining import prices (mainly as a result of stronger sterling), consumers can now consider big-ticket purchases and house moves with more confidence.
Improving business confidence: The resounding defeat of Jeremy Corbyn’s Labour Party removes a key blockage for business investment in the UK. While uncertainty over future trading arrangements with the EU remains, a move in the direction of political clarity seems likely to unlock latent investment. A recent flash PMI in January positively surprised at 52.4, hitting a 16 month high.
Improving investor confidence: UK equities had become deeply unloved by global fund managers. For an investor who could allocate anywhere in the world, the incentives to confront uncertainty in the UK, even in the face of attractive valuations, were not sufficient. However, the most recent BoAML Fund Manager Survey shows a sharp drop in the number of managers saying they are underweight UK and clearly suggests that UK equities are back on the menu for global fund managers, reintroducing a source of capital to the UK equity market that can narrow the valuation discount and drive a recovery in share prices.
How should we invest to maximise the opportunity?
Given this evolving backdrop, an active, value-biased approach seems best placed to capture opportunities in the UK market. At an aggregate level, the UK market is relatively international in its nature, meaning that a passive investment will largely reflect holdings in global businesses such as Shell, Unilever, GlaxosmithKline, and so on.
The FTSE All Share index generates only around 30% of its revenues in the UK. A strategy that can reach further down the market capitalisation spectrum into mid and small caps will be better placed to access some of the most promising investment opportunities in the UK market.
Additionally, a contrarian strategy which can unlock the value in unloved companies can sift through the large number of domestic UK companies that have fallen out of favour to find the best opportunities. A selective approach to risk-taking, based on thorough research and proper diversification will be key to delivering attractive long-term risk-adjusted returns - political risk is not the only risk facing UK equity investors today. Risk factors such as ongoing disruption and excess leverage in some companies will need to be navigated, with rigorous bottom-up analysis.
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