We have a landmark alert on UK stocks. The FTSE 100 has breached 7,000 and closed on Tuesday within a whisker of its all-time record, set last year. The FTSE 250 index of smaller companies, more dependent on the UK economy, is at an all-time high? What explains this, and can it still be a time to buy?
Discussions of UK markets have grown unavoidably political. So it is as well to get the importance of the currency and Brexit out of the way straight away.
The pattern of the UK’s performance looks wholly different when viewed in dollar terms; the FTSE 100 is down slightly for the year in dollars, and lags behind FTSE’s index for the rest of the world by seven percentage points. Substantially all of that gap has opened up since the Brexit referendum in June, which initially caused stocks to fall globally. Stocks in the US made a full recovery; stocks in the UK did not, unless you measure them in the UK’s depreciated currency.
Longer term, this continues a trend of savage British underperformance. Since a peak in 1998, the FTSE 100 has underperformed the rest of the world by 50 per cent in dollar terms, according to FTSE.
What more can be said of the Brexit referendum is that it did not spark the systemic event that had been feared. The huge one-off devaluation sterling suffered at the time did not put any hedge funds or banks out of business, and has instead acted as a shock absorber that has stopped other UK assets from falling further.
The facts that UK stocks have lagged behind the world badly since the referendum, in common currency terms, and that the pound has dropped to a fresh 31-year low since UK politicians started saying over the weekend that they were prepared to suffer a “hard Brexit” in return for regaining control of migration, show that international markets perceive Brexit as risky, and potentially harmful for the UK economy.
There are other ways in which the FTSE’s rally is not as impressive as it appears. It trades at a huge multiple of 69 times trailing earnings (exceeded only during the earnings recession of 2009 and at the top of the tech bubble), and the gains have been concentrated in the materials and mining groups that populate the London market. Anglo-American has trebled this year, while Fresnillo and Glencore have more than doubled; all are rallying from a severely sold-off position, and rely on a continued recovery in commodity prices. While a recovery in earnings is likely, it has already been priced in.
With those arguments over, can it make sense for foreign investors to invest in the UK? That rests on two issues. First, there is the currency, which has dropped to a 31-year low. Second, we need to know the prospects for UK-quoted companies.
On the currency, the fall has been spectacular, and a hard Brexit is now at least partially priced in. It is plenty possible to imagine a fresh wave of negative sentiment taking over the currency if the Brexit talks go badly. That is a real risk. But there is at least a case for entering now; sterling has probably not hit bottom, but this could easily look like a good entry point.
On the macroeconomy, there is reason for some optimism, at least for the next year or two. Leaving Brexit to one side, Chris Watling of Longview Economics points out that money supply growth has risen sharply in the last year, while the pace of reversing home equity extraction (or paying off mortgages) has halved. Taken together these data points suggest that years of cheap money have at last worked, and that Britons have stopped paying down debt and begun to spend money on things. This would explain why the economy has proved so resilient to the shock of the referendum, at least so far. And it would suggest some kind of a floor under sterling.
This is good news for domestic companies. They will have to pay more for anything they import, thanks to the weaker pound — but the currency should also help to protect them against imports, so they may well have the power to pass this on to consumers.
Barring a disastrous exit, this sounds like a decent case for growth — certainly stronger than can be found on the continent. But against this, there is a problem finding value.
Anyone looking for solid value stocks in the wake of the Brexit sell-off will be disappointed. The rally since then, in local currency terms, has left almost nothing compellingly cheap. For example, the screen for both quality and income used by Société Générale’s Andrew Lapthorne, which requires well-supported and consistent earnings as well as dividends, finds only two UK stocks that qualify: AstraZeneca and BAE Systems. Weakening the standards slightly, by dropping the required yield from 4 to 3.5 per cent, only adds another two, in Booker and Tate & Lyle.
The case for a convinced move into the FTSE 100, at least this side of the formal start to Brexit negotiations next year, therefore still looks hard to make. There is still the risk of downside on the currency, even if that is somewhat limited at this point, and there is still far too much potential downside on stocks.
Cautious moves into sterling itself, and into domestically-oriented stocks that stand to benefit from the pick-up in economic activity, however, do seem to make sense for those with a longer time horizon. Given the intense political emotions that still roil all discussions of Brexit in the UK, there should be some reward for those who stay dispassionate and move with caution; others will have made too many mistakes.