Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, investors should consider staying the course. Though developments and headlines associated with the United Kingdom’s Article 50 negotiations with the European Union have been and likely will remain fitful, they reflect more the political nature of the process and less the underlying fundamentals of the economy and its listed equities. Regardless of the ultimate outcome of Brexit negotiations and its future impact on the domestic economy, we believe that UK stocks are defensive in nature. They are fundamentally somewhat insulated from an adverse “hard Brexit” scenario, valuations are undemanding, and foreign investors are already underweight, providing some protection if a downside case were to unfold.
Two key leaders of the UK government’s Brexit strategy recently resigned in protest of British prime minister Theresa May’s proposed framework for a future UK/EU trading relationship, highlighting the fraught nature of the Brexit process. The United Kingdom’s intended withdrawal from the EU falls very much in the category of political beasts, which tend to behave erratically and whose ultimate paths are notoriously unpredictable. Setting aside the fraught political dynamics, the UK economy has, thus far, been fairly resilient since the June 2016 referendum, though both actual and potential growth have declined amid the uncertain outlook.
The UK sterling has been a proxy for Brexit risk since the referendum and therefore has weakened in recent months as political uncertainty has increased, with the pound’s short-term correlation with UK equities becoming slightly positive. The sterling’s valuation remains somewhat below its historical average on a trade-weighted basis, despite recovering some of the steep losses suffered in the vote’s immediate aftermath, but the pound is no longer outright cheap. A more adverse Brexit scenario than what has been proposed by the May administration would likely pressure the pound. In the unlikely, but not unthinkable, scenario in which the United Kingdom “crashes out” of the EU without the two sides agreeing to terms of the withdrawal, the UK economy would experience a major supply shock. The pound likely would suffer the bulk of the damage, but no domestic assets, including UK equities, would be immune in the immediate aftermath. Stocks with high domestic sales exposure and companies that import large proportions of their raw material inputs, examples of which are more common among smaller-capitalization names, would be most vulnerable in such a scenario.
Absent a disorderly Brexit, UK stocks exhibit defensive characteristics that could help mitigate some downside risk if Brexit uncertainty remains escalated for a time between now and the March 2019 withdrawal deadline or in the event of a global bear market for equities, regardless of the catalyst. The UK equity market, particularly the large-cap FTSE® 100 and MSCI UK indexes (due to their concentration of multinationals), is the least domestically oriented of any major region, deriving less than one-third of revenues at home. As a result, the performance of UK stocks relative to broader developed markets has historically been negatively correlated with sterling, though that has been less true recently. The UK market also has hefty allocations to the defensive consumer staples and health care sectors, helping to minimize the market’s sensitivity to changes in global trade. In addition, UK stocks offer an aggregate dividend yield well above the global average—though, historically, their relative performance also has been negatively correlated with bond yields. This dynamic, along with UK equities’ defensiveness, could cause them to lag if reflationary trends resume.
On the valuation front, normalized metrics for UK equities remain squarely in their historical fair value range in absolute terms, and UK stocks have rarely been cheaper relative to developed markets peers, particularly versus US equivalents. This partly reflects the fact that UK equities have been a consensus underweight among foreign fund managers for some time. However, UK stocks’ relative attractiveness has been most concentrated in two outsized sectors that have faced clouded outlooks: financials and energy. Yet, though Brexit could continue to weigh on the former, fundamentals have been improving for the latter; oil & gas stocks have benefited from better supply/demand dynamics, improved capital discipline, and increased shareholder distributions. As a result, the overall UK earnings outlook for this year and next is constructive; the sell-side consensus pencils in earnings growth of 10% this year and 8% next year, roughly in line with those of global equivalents when excluding the largely one-time boost to US earnings stemming from tax cuts.
Despite reasonable valuations and defensive attributes, we remain neutral on UK equities on a stand-alone basis; they are not outright cheap in absolute terms, and they likely would lag global peers in a scenario where global growth and inflation surprised on the upside. However, we continue to recommend investors consider moderately overweighting global ex US stocks (including the defensive UK large-cap universe) relative to US equities, given today’s rather extreme relative valuation spreads.
Michael Salerno is a Senior Investment Director on Cambridge Associates’ Global Investment Research Team.