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UK index structure creating issues

UK index structure creating issues

The UK stockmarket’s exposure to commodities is higher than even that of emerging market indices, casting doubt on domestic equities’ ability to outperform in the near term, according to Credit Suisse.

The bank’s latest global equity strategy research note said the contraction in emerging market-listed resources sectors meant the UK was now well ahead in terms of commodities exposure.

Figures from Credit Suisse and Thomson Reuters show 18 per cent of UK equity market capitalisation is exposed to resources, compared with just 11 per cent in emerging markets.

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This exposure was underlined last week when commodities trader Glencore slumped 29 per cent on September 28, dragging other UK resources stocks down with it and prompting a 2.5 per cent decline in the FTSE 100.

Both Glencore and the index subsequently recovered those losses, but Credit Suisse’s analysis also questioned the UK market’s ability to rerate in a number of other scenarios.

Excluding resources, UK equities are trading on a 5 per cent price-to-earnings premium to global equities, with price-to-book ratios in line with peers.

The bank forecasted more trouble ahead in its base-case scenario – an acceleration in global growth unaccompanied by a recovery in commodity prices.

“The composition of the UK equity market is far from optimal should a commodity-light global recovery be experienced,” the bank’s analysts said.

“Outside of the commodity sectors, the UK equity market retains a fairly high defensive weighting that is disproportionately sensitive to emerging markets – for example, in consumer staples.”

Almost 35 per cent of revenues from UK-listed companies originated in emerging markets or commodities, the study added. This meant “the relative performance of UK equities is closely correlated with that of emerging market equities”.

Emerging markets are under pressure from falling commodity prices and struggling domestic exchange rates, and are set to experience net capital outflows for the first time since the 1980s, the Institute of International Finance predicted last week.

Credit Suisse’s analysis took as its focal point the MSCI UK index – which incorporates the UK’s 111 largest stocks – and it remains neutral on the asset class rather than underweight.

But the bank also has dim views of some of the domestic-focused sectors that tend to populate mid- and small-cap indices.

It has downgraded UK domestic cyclicals to underweight, based on factors including a moderation in domestic economic activity and signs of wage pressure continuing to emerge.

One antidote to all the headwinds facing UK stocks would be a period of sterling weakness, the research team said.

It noted that just 21 per cent of UK earnings were domestically focused, meaning that UK equities could outperform if sterling weakened.

However, the team predicted this was an unlikely scenario in the current environment.

“At this stage, we do not have an especially firm view on sterling,” the report said.

“If anything, we feel that expectations for the first [interest] rate hike in the UK have been pushed back a little too far.”