When the UK shocked the markets by voting to leave the European Union on 23 June, the immediate reaction was one of fear and panic, with investors rushing to offload UK stocks—whatever the price. The day after the referendum, the FTSE All Share fell 3.3%, eventually losing a total of 7% by the Monday after the weekend.
Sterling took a lot of the strain, falling 8.5% over the same period and continuing to fall beyond 27 June. Yet, the UK’s equity market recovered to deliver a total return of 17% for the year, outperforming both the MSCI Europe and the S&P 500 in local currency terms.
The UK index draws strength from significant international exposure
We can point to some similarities between today and the events of the summer of 2016. The UK equity market is unloved and the consequences of Brexit are still unknown. So why did the UK equity market perform so well in 2016?
A cursory scan of the top 10 largest stocks in the UK index—the FTSE 100—reveals a rundown of global business giants that appear at first glance to have little to do with the UK economy. Six of these companies don’t report their financials in sterling. The sterling reporters do most of their business outside of the UK. Yet these 10 stocks make up nearly 40% of the index. In fact, a huge 70% of FTSE 100 revenues are generated overseas.
As sterling fell in 2016, these foreign revenues became more valuable in pounds sterling, driving the UK equity market higher. Meanwhile, the global economy was picking up—a key positive for the globally exposed UK equity market because it underpinned broad earnings growth.
Confounding the doubters, the UK economy did not immediately give up the ghost. Indeed, it has remained remarkably robust since the vote, with growth still firmly in positive territory. As a result, UK-exposed revenues were not hit as badly as some had feared.
The four key pillars of support for the UK equity market:
Since Brexit, the UK equity market has represented an underweight for many asset allocators. That’s because they have struggled to separate Brexit and its potentially negative impact on the domestic UK economy from the globally exposed UK equity market.
Support from sterling
While we can’t predict the outcome of the Brexit negotiations, we do know that sterling will weaken if we are left facing a hard Brexit scenario. Indeed, we have already seen this in evidence over the summer, with an escalation in Brexit concerns causing a sell-off over 6% in sterling since the April high.
A look back at history shows us that when sterling weakens, the UK equity market typically reacts positively. This happened in 2016, but also in 1992, when the UK left the Exchange Rate Mechanism: sterling declined 29% from peak to trough, while the FTSE All-Share rose 26% in the same five-month period.
In common with Brexit, this event sparked a groundswell of negative sentiment for the UK economy, with MP Paddy Ashdown stating that the government had “lost control of the economic situation.” Perhaps, controversially, this suggests a no-deal Brexit could be a positive for UK-based investors.
UK equities currently look cheap
Investors’ concerns about investing in the UK equity market are illustrated by its cheap valuation at present. According to research from Morgan Stanley, the UK’s relative valuation is close to a 30-year low vs. the MSCI World index. Dividend yield is around the 4% level which is a premium compared to all other major markets and provides a defensive support to the valuation.
Investors may not have engaged with this valuation opportunity, but corporates have not shied away.
UK buybacks have hit a six-year high, indicating that management teams view their equity as cheap and that they have excess cash to deploy.
M&A activity has been on the rise, led by Softbank’s approach to ARM Holdings in July 2016—a deal that capitalised on sterling weakness to bag a world-class business at an attractive price. More recent deal activity includes international- and domestic-focused companies such as Sky, eSure and Shire. More than £295bn of deals (both quoted and unquoted) have been completed in the UK —equivalent to over 11% of the FTSE All-Share’s total market capitalisation.
The UK tends to outperform when cycle indicators have peaked
While we don’t believe this is the end of the global cycle, it’s worth remembering that the UK has historically outperformed in a late-cycle environment thanks to the defensive composition of the index. As a result, in an environment where cycle indicators have peaked, sectors to which the UK is heavily weighted—energy, staples, utilities and pharmaceuticals—have historically tended to outperform.
Money flows could return to the UK
Data from Bank of America Merrill Lynch’s Fund Manager Survey shows that allocations to UK equities are net 28% underweight, making it the least popular country in Europe. This underweight implies investors have considerable concerns about Brexit, which are unlikely to be assuaged in the short term as negotiations continue. It suggests that if a benign Brexit can be negotiated, then money could return to the UK.
Challenge spawns opportunity
It’s fair to say that the UK equity market is unloved at the moment, and with the UK’s EU exit date swiftly approaching, it is understandable that investors are concerned. Yet these fears are misplaced; indeed, they are actively creating an opportunity. The market is cheap, which is sparking corporate interest. What’s more, it seems well-placed to outperform as the global cycle matures. Further, if the outcome of Brexit is more favourable than anticipated, investors could reallocate to UK equities as fears subside.
Callum Abbot is a portfolio manager for the JPM UK Equity Core Fund.
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