Investing: Are UK equities a sterling opportunity?

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on July 2, 2018 - July 08, 2018.

Milligan

Smith

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UK equities had a bad start to the year. By the end of the first quarter, the FTSE 100 was the worst performing major European index. A Bank of America Merrill Lynch (BAML) survey of fund managers in March called the index the main “big short” of the respondents as they expected it to continue falling.

While the FTSE 100 recovered in June to levels before the decline, opinions on the UK market remain mixed. Some view the Brexit discussions as a source of uncertainty that will affect the direction of the market and the pound sterling. On June 20, the currency hit a seven-month low due to a vote on the Brexit deal.

Nevertheless, there are investors who see opportunities to buy UK equities amid the volatility. For instance, the latest BAML survey in June showed the lowest number of investors underweighting UK equities this year.

In Edward Smith’s 12-month outlook, he says it is not time to give up on UK equities yet and the market remains one of the most rewarding for stock pickers. The head of asset allocation research at Rathbone Investment Management observes that three of the four conditions on which it will have to upgrade the FTSE 100 have been met in the last six months — the weakening of the US dollar against emerging-market currencies, firmer oil prices and lower valuations relative to other large-cap Western indices. The unmet condition is a pickup in global mergers and acquisitions activity.

The foreign selling of FTSE stocks has been indiscriminate, says Smith. “Although more than 70% of the FTSE 350 earnings originate outside of the UK and 50% outside of Europe, all companies are being tarred with the same brush. Indeed, the quintile of companies least exposed to the UK have performed no better than the quintile most exposed to the UK over the last 18 months.”

The FTSE 350 is a combination of the FTSE 100 and the mid-cap FTSE 250.

Andrew Milligan, head of global strategy at Aberdeen Standard Investments, is neutral on UK equities. “We are not in the camp of ‘It is a screaming buy on valuation grounds’, which some people do, and we are not in the camp that says, ‘No, there is far too much political risk with Brexit’,” he says.

Milligan believes that there are interesting stocks and sectors within the UK market, but the issue is that they are not as interesting as the opportunities in other parts of the world. For instance, technology stocks — which have been driving returns globally — have less of a presence in the UK stock market.

He says the UK has very low weighting on technology, compared with Asia or the US. Apart from that, the FTSE has a pretty good mix of sectors for international investors. The FTSE 100, which lists the 100 largest companies traded on the London Stock Exchange, has the highest weightage for oil and gas (17%), followed by banks (13%), according to index provider FTSE Russell. Its weighting for technology was less than 1% as at May 31.

Meanwhile, the UK economy is growing slowly. Last month, the British Chambers of Commerce cut its UK growth forecast for 2018, warning that the economy would face its weakest year since the 2008 global financial crisis. This makes the UK a less compelling destination than countries that are experiencing rapid growth, such as the US.

“The UK is currently a slow-growth economy. It was previously able to grow at about 2% to 2.5% a year. The economy now seems stuck at about 1.5% a year. There was considerable pressure on the consumer sector from weak real income growth and the pickup in inflation,” says Milligan.

Political uncertainty due to Brexit will continue to hamper the performance of UK equities. The government has yet to hammer out the details of the separation, with the transition period to last until December 2020.

“There is still considerable uncertainty about Brexit and what it will mean for the UK. There may be a World Trade Organisation-style exit, which will be very painful for the UK. Or the government may fall, and the new Labour government may come in and have very different policies,” says Milligan.

A WTO-type exit may mean tariffs on exports and no free movement of people; the UK also cannot be a member of the single market, according to an analysis by the BBC.

Smith observes that political events may have caused the fundamental relationship between macro factors and market performance to break down. “The FTSE 100 has underperformed the MSCI World by far more than seems justified by the performance of three macro factors with which it has had a very close historical relationship — the pound sterling exchange rate, oil prices and the Asian economic momentum. Asia accounts for a considerable amount of marginal earnings growth in the FTSE 100,” he says.

Other factors that have led to the underperformance is the UK’s high exposure to sectors such as banking, oil and gas and mining — which went through a challenging trading period — as well as a lack of exposure to high-growth areas such as technology, according to Rathbone’s second quarter Investment Insights report.

US-based Russell Investments notes in its second-quarter report that it will continue to underweight UK equities due to their underperformance, concerns about political uncertainty and slowing economic growth. UK-based Aviva Investors says in its second quarter house view report that it is underweight on UK equities due to Brexit-related risks.

However, there are fund managers who remain optimistic. James Henderson, director of UK investment trusts and fund manager at Janus Henderson Investors, sees opportunities to buy companies with good businesses at attractive valuations. In a June 20 note, he wrote that the worst possible outcome of Brexit had already been priced into UK equities, which means valuations have much room to grow.

Andy Brough and Jean Roche, head of pan-European small companies and fund manager of UK/Euro small cap at Schroders respectively, wrote in an April article that active stock pickers will be rewarded in the UK as the divergence between the best and worst-performing shares is widening. In their view, UK mid caps could offer great opportunities.

 

Where are the opportunities?

Milligan’s strategy for investing in UK equities is to be sector and stock-specific. For instance, stocks in the fast-growing technology-related sectors and the internet spending sector are interesting to him. But he would stay away from consumer staples, utilities, telecommunications and media for now. Companies with a focus on overseas markets also offer good opportunities, such as sporting goods retailer JD Sports, which exports to Europe and Asia.

“Boohoo and Just Eat are two of the e-commerce winners. We used to own Asos, which is rapidly turning into one of the big internet fashion names. We may be underweight on supermarkets and classic media, which are being affected by consumer spending, but there will be winners,” says Milligan.

Boohoo.com is an online fashion brand while Just Eat is a global marketplace for online food delivery.

While the UK does not have big hardware producers or internet service suppliers like Google and Amazon, companies such as Boohoo — which are using technology to create disruption — can be a proxy to the sector.

“Perhaps investors are paying too much attention to the FANG stocks, but there are many other companies that will benefit from this shift such as the transition from 4G to 5G. From the financial technology (fintech) point of view, London is still the centre of Europe and the amount of fintech expansion taking place there is phenomenal. But of course, these companies have not been floated on the market yet while there is considerable investment taking place,” says Milligan.

He expects growth to stabilise at 1.5% and pick up pace towards the second half of the year. Consequently, some domestic players — such as housebuilders, real estate companies and banks — may benefit from the moderate recovery. The government’s support for building more affordable and mid-range housing will translate into some opportunities. Another emerging area is online gambling.

“There was a US court decision in June to allow more gambling across the country. UK and Irish technology is a world leader in internet gambling and a number of companies there look to benefit enormously in the competition with their US counterparts,” says Milligan.

A longer-term theme he observes is defence. “We are in a much more geopolitically risky world than 10 or 15 years ago. You can see country after country increasing their defence budget. Defence is an area that the UK is strong in,” he says.

 

When to go into the market

Investors interested in UK equities could observe the direction of the pound sterling and the US dollar. That is because 76% of the FTSE 100 companies derive their revenue from outside the UK, so their earnings are translated into the UK currency, according to FTSE Russell.

“If the dollar rises, the pound sterling falls. The translation effect means that the FTSE 100 is pushed higher, which is what we saw in March, April and May. Another way of thinking about this as an investor is to say ‘What do I think about the outlook for the US dollar for the rest of the year or going into 2019?’,” says Andrew Milligan, head of global strategy at Aberdeen Standard Investments, who is neutral on UK equities. The pound sterling lost about 4% against the US dollar in those three months.

The currency perspective is shared by Edward Smith, head of asset allocation research at Rathbone Investment Management. “When thinking about long-term returns, it is important to remember that the proportion of FTSE 100 corporate revenues originating in high-growth Asian and emerging markets is larger than most other Western bourses. That should also propel returns over the longer run,” he says.

In Smith’s 10-year outlook, it is not time to materially decrease strategic, long-term allocations to UK equities for pound sterling-based investors because the UK currency is undervalued against all major currencies. If the pound sterling is bound to appreciate in the long term, the returns from overseas equities are likely to diminish.

“Although exchange rates are near impossible to forecast in the short term, there is a deep pool of evidence that shows that exchange rates have a very powerful relationship with some fundamental economic relationships over the long term. Whether that is purchasing power parity or our preferred Behavioural Equilibrium Exchange Rate framework — which looks at relative prices, relative productivity and relative savings — all these suggest that the pound is very undervalued,” says Smith.

“That is still the case even when we adjust for a really adverse Brexit. Indeed, against the euro, it is still undervalued almost by as much as it has ever been in the last 35 years.”

According to Rathbone’s report, the FTSE 100 should be able to deliver decent long-term earnings growth. Its significant weighting to energy, mining and consumer staples will give investors the best exposure to higher growth regions — especially Asian emerging markets — among other Western markets.

However, investors who are interested in entering the UK market should note that the FTSE 100 is currently at relatively high levels compared with its dip in March. “This is a relatively expensive time to buy into the market. If you want to time the market, it was as low as 7,000 points only a few months ago. If investors are happy to time the market, they may want to hold off and look for some of the pullbacks that will take place, such as easing on economic concerns or changes in politics and Brexit,” says Milligan.