UK stocks: cheap but unloved ahead of Brexit

Weakness in sterling has meant that UK equities are cheap relative to other parts of the world. But Brexit means that they are cheap for a reason.

UK earnings so far have not been all bad, despite the impending Brexit deadlines. But the monthly surveys of fund managers continue to point to UK assets being underweight in portfolios. The uncertainty around Brexit continues to make predicting the future for UK markets even more difficult than normal.

The weaker pound, which some have suggested is as much as 20% undervalued, is one key reason why UK stocks look cheap compared to others around the globe. But for investors, UK equities appear to be cheap for a reason.

Brexit could still go in a number of directions, investors fret. From a ‘no deal’ that sees the UK crashing out of the bloc, to a managed withdrawal under the terms of the Prime Minister Theresa May’s deal, to an extension of Article 50 that might even set the stage for a second referendum, the various possibilities deter investors, pushing them to look elsewhere.

Indeed, even in a scenario where the UK’s exit from the EU is cancelled altogether, the upside for UK equities may be limited. Such an outcome would be bullish for sterling, but the net effect, at least in the short term, might be to push the pound higher, weighing on the FTSE 100, although potentially providing a tailwind for the domestically-focused FTSE 250.

Finance is the one area where the UK and the EU are at least taking steps to cooperate. Both sides would suffer if markets sold off dramatically, and thus it is in the interests of both to have contingency plans in place to essentially keep everything unchanged and allow the smooth functioning of markets. Key areas such as derivatives and their clearing houses have already been provided with the support of both sides to allow operations to continue as normal, in order to avoid a freeze in funding activities across Europe.

For the banks, a slump in the pound would send shockwaves through the UK economy, causing higher inflation, a dramatic hit to consumer spending and confidence and cause lending to come to a standstill. Recent earnings from the sector have been mixed, but there was notable improvement in the position of Royal Bank of Scotland (RBS) and Lloyds. A no deal scenario might threaten to undermine this good work.

Housebuilders too would suffer from a weaker pound. Inflation has already pushed costs up, hurting margins, and a complete rupture would see demand for new housing drop still further. While the sector trades at a relatively low valuation, this would seem justified by the headwinds facing the UK economy.

The UK remains an unloved part of the global equity marketplace, but it is also relatively small in weighting terms, being around 5% of the MSCI World index compared to over 50% for the US. There are other opportunities for fund managers, so it is unlikely that the UK will leave the category of ‘least crowded trades’ for some time.

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