On March 29, the British prime minister Theresa May triggered Article 50 of the Treaty of Lisbon, setting in motion a two-year negotiating window for Britain to thrash out a deal for leaving the European Union.
The surprise Brexit referendum result in June last year sent shock waves around the world. A fair amount of short-lived panic ensued. However, the UK economy has since consistently defied expectation with growth remaining strong, at or above trend.
Many market participants are quick to point out that Britain has not actually left the EU yet but, standing back, it is also evident that the risks are well documented and significant bad news is already reflected in pessimistic expectations.
Investing during periods of elevated uncertainty can lead to great opportunities for investors who position themselves to take advantage of exploitable mispricings. Disaggregating the UK-listed securities market highlights segments pricing in the most pessimism where opportunities can be found, in our opinion.
On a headline basis the UK stock market has been a strong participator in the global equity market rally, which started in June last year. Since the day before the referendum, the FTSE 100 and FTSE 250 indexes are each up double digits in sterling terms. These rosy headline figures mask abnormal dislocations beneath the surface. Specifically, there has been extreme divergence between the share price performance of UK-listed exporters and UK-listed domestic companies.
Companies that export the majority of their goods and services outside the United Kingdom have appreciated in value by about 30 per cent on average over the period. A weak pound is generally good news for British exporters as the cost of their goods and services is more competitive abroad.
Meanwhile, companies that sell domestically in the UK have not participated in the global equity rally. Many UK-focused companies are trading at a material discount to their pre-referendum levels; reflecting substantial underperformance versus local and international equity indices. This underperformance represents a perception of very low prospects for UK domestics.
Scrutinising the underlying economic data, one can see that, following the referendum result economists and equity analysts rushed to slash their outlook for UK growth. GDP expectations stand about 1 per cent lower than this time last year. Company earnings forecasts for domestic businesses have fallen materially, while the pound’s weakness has provided an offset for exporters’ earnings once repatriated into sterling.
Downgrades to earnings expectations have been combined with a de-rating of domestic equities. The relative price/earnings ratio of the two segments is at a much wider discount than is normal. Importantly, and perhaps the best indicator of investor sentiment, global equity portfolio managers are very underweight about the UK as a region. Contrary to the market’s negative Brexit impulse and gloomy news headlines, macro data and lead indicators have held up well and actually surprised positively. Surveys of investment intentions have increased since the start of the year and March’s services PMI delivered a strong and unexpected gain. Deconstructing the PMI shows the domestic component is displaying unexpected resilience, while a healthier global backdrop is supporting the region more than many analysts have allowed for.
Critically, while UK economic momentum may well slow in the months ahead, it is essential to remember that it is already anticipated. The bar is low and UK-focused businesses have already underperformed despite resilient data.
A more benign Brexit could see a reversal in the extreme divergence between UK domestic cyclicals and exporters.
Extreme market dislocations provide a great environment for stock pickers who are able to cut through the noise and focus on what a stock is really worth.
In our opinion, market dislocation is currently creating opportunities in some UK banks, Reits and retailers.
Grace Peters is a senior equity strategist for the JP Morgan Emea Private Bank.
business@thenational.ae
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