Weekly Digest

UK equities: unloved and underrated

Andrew Hardy, CFA

17 September 2018

With Brexit looming many of our clients have asked us how we are managing exposure to UK assets within our global portfolios. The challenge of positioning portfolios appropriately for Brexit, be it to mitigate risk or take advantage of potential opportunities, is tough as the negotiations could go either way: an acceptable future trade relationship with the EU or a no-deal outcome. These potential outcomes would have substantially different implications for investors.

We have always held the view that a deal will ultimately be done, primarily because it is so plainly in the interests of both parties to do so, but the risks of a no deal outcome have clearly increased recently. It may be a long time before any degree of certainty is delivered, as the original intent to have in place a detailed outline agreement for the future relationship at the same time as the exit arrangements will likely be softened, if nothing else because time is running out and key issues seem far from being agreed. All of this spells heightened uncertainty, particularly among the business community.

Investors have shunned UK assets in the past two years leaving the equity market undervalued. Large cap UK equities are priced at a forward earnings multiple of just 13x and a dividend yield of 4.3%, compared to 17x and 1.8% for US equities respectively*. The spread between the UK market’s dividend yield and the 10 year gilt yield is close to the highest levels in over 20 years.

An acceptable deal should see sterling and UK equities rise, possibly substantially. Under this scenario sterling should also be supported by the likelihood that the Bank of England would be emboldened to lift interest rates further. On the other hand a no deal outcome would undoubtedly see sterling take the brunt of investors’ worries about the potential damage to the UK economy. The Bank of England might then even loosen monetary policy as it did immediately after the referendum. UK equities would probably decline; led lower by domestically focused small and mid-cap companies, but as we saw in the referendum’s aftermath, many large caps could perform well as they derive most of their revenues from overseas.

Taking an extreme position based on an expected outcome to the negotiations is risky given the widely divergent impact on markets of the possible outcomes. Instead we have kept exposure to the UK reasonably balanced in portfolios, focusing on large cap equities as these should do relatively well in either outcome. We have no exposure to UK gilts in most portfolios. Furthermore, we reduced sterling currency exposure in many portfolios earlier this year in favour of increased US dollar exposure, just before this extended period of US dollar strength began. Should sterling fall significantly further between now and Brexit day we would view this as an opportunity to rebuild exposure.

We are optimistic about the prospects for the UK in the long term. A no deal scenario would be damaging to confidence, the economy and markets in the short term but we would not expect this to be long lasting, while an acceptable deal which keeps a free trade relationship with the EU and allows the UK to enter into free trade arrangements with other countries would be a bullish outcome. We acknowledge the shorter term risks but we also recognise that a successful deal will be very positive for UK markets, hence the need for a measured approach to portfolio construction in what are especially uncertain times.

*MSCI index data, as of 31st August 2018

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