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Opportunity knocks for UK stocks

Opportunity knocks for UK stocks

If someone told you the UK would vote to leave the European Union, but that the UK equity market (FTSE All-Share) would deliver a total return of 17 per cent for the year, outperforming both the MSCI Europe and the S&P 500 in local currency, you would have been forgiven for being sceptical, yet that is exactly what happened. 

The market was weak when it opened on the 24 June 2016, falling 3.3 per cent on the day and falling again on the Monday after the weekend, taking the total decline to 7 per cent. The initial, emotional, reaction was one of fear: get me out of these UK stocks at any price.

Another asset that took a lot of the strain was the pound sterling: down 8.5 per cent over the same period and, unlike the equity market, sterling continued to fall beyond the 27 June. 

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It is possible to see similarities today with what happened in the summer of 2016. The UK equity market is unloved and the consequences of Brexit are still unknown. 

Why did the UK equity market perform so well in 2016? 

Key Points

  • Sterling took a hit the day after the Brexit vote
  • Most FTSE companies get a large part of their earnings from overseas
  • The UK equity market is cheaply valued at present

To the uninitiated, casting their eyes down the top 10 largest stocks in the FTSE 100, they would be forgiven for not associating these global business behemoths with the UK economy.

Six of them do not report their financials in sterling and even the sterling reporters do the majority of their business outside of the UK. Yet these 10 stocks make up nearly 40 per cent of the index. This international bias is common throughout the index: 70 per cent 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. Equally, the global economy was showing signs of accelerating – a key positive for the globally exposed UK equity market as it supported broad earnings growth. 

The UK economy did not instantly capitulate, as some had feared. In fact it has remained remarkably robust since the vote, with growth remaining firmly positive. Thus, UK exposed revenues were not as badly impacted as had been expected.

State of play

Following Brexit, the UK equity market has been a perennial underweight for many asset allocators as they have been unable to separate Brexit and its potentially negative connotations for the domestic UK economy from the globally exposed UK equity market.

The UK economy has performed better than expected, growing at 1.7 per cent in 2017 despite Brexit-related uncertainty and a sharp decline in sterling. The UK Composite Purchasing Managers Index is currently at 54 (as at August 2018) with any score above 50 viewed as expansionary. 

Unemployment is at a 40-year low and real wage growth has recently returned. Monetary policy has tightened slightly but remains accommodative.

On the fiscal front, the UK budget surplus in July 2018 was the largest since 2000 due to better than expected tax receipts.

The outcome of the Brexit negotiations is not something this article will speculate on. We do know that sterling will weaken in the event of a hard Brexit scenario. This has been well demonstrated over the summer where rising Brexit concerns have seen the currency sell-off over 6 per cent since the April high.