Having been one of the fastest-growing economies in the G7 for several years,
while the global economy emerged from the depths of the 2008 financial crisis in 2012, the UK finds itself at the bottom of the class for 2018, a position that it looks likely to retain into 2019.
The ‘good’ parts of the economy include manufacturing, which has shown one of the longest periods of unbroken growth since the 1960s, and exports, which are going from strength to strength, especially given the boost from a weaker sterling seen since the referendum. This has also had the side-effect of a welcome improvement in the trade balance in recent months.
Devil in the retail
Leading the ‘bad’ factors in the economy is the weakness in retail sales, which saw a high of approximately 6% growth year-on-year (YoY) towards the end of 2016, but has steadily decelerated since, to the point where the YoY growth is now around 1%. UK consumer confidence has been deteriorating over a period of several years as wage growth has failed to keep pace with inflation, eroding disposable income. This can clearly be seen, for example, in the fall in UK car sales which have also been hit by the loss of appetite for diesel cars. On the ‘ugly’ side, the construction sector has been and remains extremely weak. It fell 3.9% YoY in January 2018 and has been consistently falling for the past nine months. Commercial property developers are not prepared to commit to longterm developments given the uncertain outlook, with house-building slowing after a stronger period of growth in 2017. The particularly poor number in January could be attributed to the impact of the collapse of Carillion, but the sector remains in a poor shape generally.
Although it has recently been signalled that the UK budget deficit has returned to the government’s target of less than 2% of GDP this year, the outstanding debt to GDP (currently at approximately 85%) does not leave much wiggle room for the fiscal expansion that is called for in some areas.
Real GDP growth
Source: Datastream, February 2018
These and other factors have led us to maintain and even increase our underweight position in UK equities over the past year. With hindsight, this has proved to be a decision that has positively contributed to returns. Since the beginning of 2018, the FTSE 100 has lagged behind other global stock markets in the US, Asia and Europe by a considerable margin. The US S&P 500 Index is around 8.5 percentage points ahead on a common currency basis although this has been partially mitigated by the weaker US dollar, as the difference is nearer 4% in sterling terms as at 23rd March 2018.
The key question is whether this underperformance of the UK equity market will continue.
UK manufacturing vs construction output
Source: Datastream, February 2018
One of the big causes of underperformance in the UK equity market – especially relative to the US, Asia and emerging markets – is the under- representation of the higher-growth areas where stocks such as technology. This has a substantially lower weighting in the UK index, and has been an area of notable outperformance for the past few years, driven by the likes of Amazon, Google, Facebook and Netflix. The US equity market has a weighting of over 25%, whereas the UK has somewhere nearer 1%. This gap is not noticeably narrower for Asia and emerging markets, where stocks such as Baidu, Alibaba, Tencent and Samsung have had a similar impact.
The UK market has a higher representation of more cyclical sectors (such as financials, resources and energy) than other regional indices, and these are sectors that until recently have lagged behind the broader indices.
From a valuation point of view, the UK market is at a discount relative to other global markets on an earnings yield and dividend yield basis. A lot of that difference can be explained by the differing sector composition explained above. Within the market, there has been a clear divergence in the performance of stocks. Of those with a high proportion of international earnings, 70% come from outside the UK. Conversely, of stocks that have a high proportion of domestic earnings, 70% come from inside the UK.
The market’s derating has come through a fall in the price/earnings valuation as the earnings have actually risen since the beginning of 2016, significantly helped by weaker sterling. However, it is also one of the few markets in the world that yields more than its domestic, investment-grade bond market.
There are a number of surveys that try to track the positioning of investors, one of the best-known being by the Bank of America Merrill Lynch. In its February survey, the UK equity market was the least favourite market for investors, with the most negative reading ever seen in the lifetime of the survey. The key risks to the UK market are predominantly political and the range of outcomes is wide. Possibilities include a tougher or more pro-business trade deal and transition period with the EU, or the potential impact on the market from a collapse in the government and another general election (although the latter is not in our central case).
So is it time to buy into the UK equity market? Although it is cheap and unloved, the structural headwinds it faces through having a different sectoral composition may persist in the medium term. Although the market will have bouts of outperformance, it will still feel as if the hand brake has been left on.