SINGAPORE (July 9): UK equities had a bad start to the year. By the end of 1Q2018, the FTSE 100 was the worst-performing major European index. A Bank of America Merrill Lynch (BOAML) 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 pound sterling. On June 20, the currency hit a seven-month low, owing 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 BOAML survey in June showed the lowest number of investors underweighting UK equities this year.
Edward Smith, head of asset allocation research at Rathbone Investment Management, says in his 12-month outlook that it is not time to give up on UK equities yet; the market remains one of the most rewarding for stock pickers. He observes that three of the four conditions on which Rathbone 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’ and we are not in the camp that says ‘No, there is far too much political risk with Brexit’,” he says.
Less weightage on tech stocks
Milligan believes 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 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, owing 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 2Q Investment Insights report.
US-based Russell Investments notes in its 2Q report that it will continue to underweight UK equities, owing to their underperformance, concerns about political uncertainty and slowing economic growth. UK-based Aviva Investors says in its 2Q house-view report that it is underweight on UK equities, owing 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, such as sporting goods retailer JD Sports Fashion, which exports to Europe and Asia, also offer good opportunities,
“Boohoo.com 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 such as Google and Amazon.com, companies such as Boohoo.com — which are using technology to create disruption — can be a proxy for the sector.
“Perhaps investors are paying too much attention to the FANG [Facebook, Amazon.com, Netflix and Google parent Alphabet] stocks, but there are many other companies that will benefit from this shift, such as the transition from 4G to 5G. From the 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 and there is considerable investment taking place,” says Milligan.
He expects growth to stabilise at 1.5% and pick up pace towards 2H2018. 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 says, 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.”
Tan Zhai Yun is a writer with The Edge Malaysia
