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.
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.
Meanwhile, despite noisy political posturing, the global economy continues to demonstrate strong economic growth and benign inflation.
The opportunity
• Sterling support
History tells us that when sterling weakens the UK equity market tends to respond positively. This was the case in 2016, but also in 1992 when the UK left the exchange rate mechanism, when sterling fell 29 per cent peak-to-trough while the FTSE All-Share index rose 26 per cent in the same five-month period.
Like Brexit, this event triggered considerable negative sentiment for the UK economy. Liberal Democrat MP Paddy Ashdown stated at the time that the then government had “lost control of the economic situation”.
Perhaps, controversially, this suggests a no-deal Brexit could be a positive for UK-based investors.
• Valuation
Investors’ concerns about investing in the UK equity market are illustrated by its cheap valuation at present.
Morgan Stanley research shows the UK’s relative valuation is close to a 30-year low versus the MSCI World Index. Dividend yield is around the 4 per cent level, which is a premium compared with all other major markets and provides a defensive support to the valuation.
Even though investors have not engaged with this valuation opportunity, corporates have. UK buybacks are at a six-year high, suggesting that management teams view their equity as cheap and that they have excess cash to deploy.
Merger and acquisition activity has been elevated since Brexit, starting with Softbank approaching ARM Holdings in July 2016; a deal that took advantage of weak sterling to buy a world class business on the cheap.
Recent deal activity includes international and domestic-focused companies such as Sky, eSure and Shire. Since the Brexit vote there have been more than £295bn of deals completed in the UK (both quoted and unquoted), equivalent to more than 11 per cent of the FTSE All-Share’s total market capitalisation.
• Late cycle play
We do not believe it is the end of the global cycle, but it is worth noting that the UK has historically outperformed in a late cycle environment because of the defensive makeup of the index.
In an environment where cycle indicators have peaked, energy, staples, utilities and pharmaceuticals have historically tended to outperform, which are sectors the UK is heavily weighted towards.
• Flow of money
Data from Bank of America Merrill Lynch’s Fund Manager Survey shows that allocations to UK equities are net 28 per cent underweight, making it the least popular country in Europe. This underweight implies investors have considerable concerns about Brexit that are unlikely to alleviate in the near term as negotiations continue. It suggests that if a benign Brexit can be negotiated then a flow of money could return to the UK.
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. We would argue that these fears are misplaced and are creating an opportunity.
The market is cheap, which is attracting corporate interest and is well-placed to outperform as the global cycle matures. Finally, if the Brexit outcome is more benign than expected, there is potential for a reallocation to UK equities as fears subside.
Callum Abbott co-manages the JPM UK Equity Core Fund
