Brexit-blemished UK assets look cheap — but investors are wary

Date published: 01 February 2019

Laurence Fletcher

Fund managers seem unanimous: sterling and UK stocks look cheap. But many are so perplexed by the political wrangling over the UK’s exit from the EU, that they are finding it hard to pluck up the courage to buy.

Value-focused investors have been sniffing around the FTSE 100 index, which has traded at a big discount to similar benchmarks in Europe and the US since the referendum of June 2016. The pound is down about 12 per cent over that period, according to Deutsche Bank’s trade-weighted measure, drawing some bargain hunters.

Yet sterling and UK stocks are among global fund managers’ biggest “underweights” compared with historical weightings, according to the latest monthly survey from Bank of America Merrill Lynch, meaning that they are happy to steer clear for now.

The problem is a lack of clarity over Brexit, say investors. With so many possible outcomes still on the table — from a managed transition to an abrupt departure — it is difficult to put a price on assets. Jim Leaviss, head of retail fixed income at M&G Investments, says sterling could be up to 20 per cent undervalued, based on purchasing-power metrics. But he has kept his weighting in sterling assets neutral, the same as the benchmark, because he cannot be sure of a rally.

“It’s not analysable in any meaningful way; it’s a bit like gambling,” he says. “There are things where you think you’ve got an edge, and things where you certainly don’t have an edge.”

With Brexit hanging in the balance for so long it is no surprise that sterling and UK stocks have languished. The FTSE 100 trades on 12.3 times next year’s earnings, compared with the Stoxx 600 — a European benchmark — at 13.1 times and the S&P 500 at 15.9 times. But with valuations at these levels, the key question is whether UK assets could do well whatever happens with the EU.

Markets tend to dislike unknowns. Uncertainty over a potential war in Iraq, for example, had weighed on stocks at the end of the bear market in early 2003. But once investors finally decided war had become inevitable, prices surged.

“On some measures, the UK stock market is at its lowest valuation for 30 years,” notes Paul Marshall, chairman of hedge fund Marshall Wace, which manages $39bn in assets. He adds that a “workable solution” on Brexit would help drive UK assets higher, although prolonged uncertainty would continue to be “taken badly by investors”.

Brooks Ritchey, head of portfolio construction at K2 Advisors, part of Franklin Templeton Investments, says that so many people are “short [the UK], that the surprise could be UK equities doing better than expected.” Nevertheless, he prefers betting on a recovery in Japan and emerging markets, which he thinks are “cleaner” scenarios than the UK.

The general lack of conviction can, in part, be explained by the UK’s relatively low weighting in the MSCI World index: just 5.7 per cent, compared to the US at more than 50 per cent. Missing out on a big rally, then, would be annoying but hardly career-ending for most managers. If they can find similar opportunities elsewhere, then why take on the UK’s peculiar risks?

Jacob Mitchell, founder and chief investment officer at Sydney-based Antipodes Partners, which manages around $6bn in assets, believes that while UK domestically focused companies look cheap, so do equivalent stocks around the world.

“We’d prefer to be in ING than Lloyds,” he says, comparing the Dutch lender to the biggest bank on Britain’s high street. “We’re a bit cautious on the UK economy. We don’t need to take that bet as we’re being offered similar returns without that risk.”

Despite the uncertainty, some investors are nibbling at UK assets. Sterling is up 2.9 per cent against the dollar this year, better than the yen, the euro and the Swiss franc. The FTSE 100 has crept up almost 4 per cent, more than some developed markets but less than the US and Europe.

Lansdowne Partners, one of the world’s biggest equity hedge funds with about $20bn in assets, increased its exposure to UK stocks in the three months to December, according to investor letters seen by the Financial Times.

“Barring a total collapse of the UK economy, the shares [of Lloyds] are incredibly cheap. The same increasingly applies to the other UK banks,” wrote managers Peter Davies and Jonathon Regis.

However, for some, the ongoing twists and turns of Brexit means it is better to try to make short-term profits than take a long-term view.

Jeff Donlon, managing director of global strategies at New York-based Manning & Napier, which manages more than $20bn in assets, had in recent months been increasing exposure to the UK by buying domestic-focused stocks in the financials, real estate and housebuilding sectors most at risk from a no-deal Brexit. At the same time, he had been raising exposure to UK small-cap stocks and sterling. Mr Donlon’s bet had been that the probability of a no-deal had diminished in favour of a softer Brexit, or no Brexit at all.

But, as the likely outcome has shifted toward the UK and EU at a stand-off while the clock is run down, he has been cutting exposure again.

“Fears regarding a no-deal Brexit scenario being back in play [could] cause sentiment to turn negative,” he says.

“Ultimately, we’ve not solved anything.”


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