Signs of life in UK equity market flows?
The UK equity market has been firmly out of favour with investors for quite some time. Zach Chadwick explains why he believes rigorous fundamental analysis—and a flexible active approach—can unlock the market’s long-term growth.
The UK equity market has been firmly out of favour with investors for quite some time. It has been the most unloved regional market for a record 41 consecutive months in the BAML fund manager survey, and now trades at a 35% discount to the MSCI World Index—which is close to a 30-year low.
However, there are signs that things could be about to change as the UK edges towards a Brexit deal. With recent moves in sterling and a pick-up in UK equity inflows suggesting that investors are looking once again at UK assets, we think the removal of the possibility of a “no deal” Brexit could trigger a more rapid flow of money back into the UK market—and at the same time, present compelling opportunities for active managers.
To understand why renewed demand for UK equities is likely to boost opportunities for active funds, we have to look at how flows into the UK market are likely to manifest themselves.
The easiest way for an asset allocator to quickly increase their UK equity exposure is to buy an exchange-traded fund (ETF). When the chances of a Brexit deal rise, investors tend to buy FTSE 250 ETFs, or one of the many domestic UK equity baskets that have been created, to maximise their exposure to an expected bounce in the UK economy. Therefore, we’d expect to see strong inflows into domestically-focused UK index ETFs as the UK market returns to favour.
However, while market-cap-weighted ETFs provide cost effective and scalable market exposure, investors often buy an ETF without scrutinising the fund’s underlying assets. As a result, share prices of the stocks in these domestically-focused ETF baskets have tended to rise indiscriminately, whether the stocks themselves will benefit from a Brexit deal or not. It’s this indiscriminate buying that is helping to create particularly compelling opportunities for active managers.
To illustrate, let’s take a look at one such basket of domestic UK stocks: Intu, M&S and Dixons Carphone1. As the chart shows, the share prices of the basket’s constituents moved in sync following the announcement of a potential Brexit deal on 11 October.
However, I don’t think the prospect of a Brexit deal justifies a rise in the share price for any of these stocks.
Take M&S, for example, which is a constituent of the FTSE 250 and appears in many baskets of domestic UK stocks. The company runs a struggling high street supermarket operation with a cumbersome store base. Its prospects will not be transformed by a Brexit deal. As one sell side sales person said in a recent email: “At no point does anyone ask whether anything has actually changed for what is a deeply flawed business”.
Dixons Carphone, meanwhile, is a retailer of consumer electronics with limited product differentiation in a crowded marketplace. Intu is a highly levered shopping centre operator. All three stocks are structurally challenged by the shift to online retailing. And each has been de-rated for a good reason. A Brexit deal is unlikely to make trading conditions easier for any of them.
The active opportunity
If a Brexit-related pick-up in the UK equity market is driven by demand for domestically-focused ETFs, share prices of many struggling companies are likely to be pushed sharply higher, with no regard for fundamentals. Some international companies may also underperform as they are not part of domestic share baskets—again, with limited change in their fundamentals. This sort of blind buying or selling can create pricing inefficiencies that active managers can benefit from.
Take our JPM UK Equity Plus Fund, for example, which we believe is particularly well positioned to capitalise on any pricing anomalies caused by ETF buying. This is because the fund has the ability to take advantage of overpriced assets by taking short positions in the stocks that we find least attractive—freeing up additional cash to invest in the stocks that we believe have the strongest growth prospects, while carefully managing portfolio risks.
With the signs pointing towards a potential revival in UK equity demand, I believe rigorous fundamental analysis—and a flexible active approach—can unlock the market’s long-term growth.
Zach Chadwick is an analyst within the J.P. Morgan Asset Management UK equity team. Read more about our UK Capabilities >
1The securities above are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell.