British shares are back in the ring
According to Marco Bonaviri of Reyl, the UK stock market has particularly attractive characteristics: since the vote for Brexit in June 2016, it has been neglected by international investors and is now celebrating an even stronger comeback since the agreement with the EU.
Despite the measures still underway worldwide to contain the pandemic, the financial markets have been expecting the global economy to recover for many months now. "This reflationary environment is favorable for financial assets, which are most sensitive to a synchronized global recovery, the commodity cycle and interest rates", Says Marco Bonaviri, senior portfolio manager Reyl. In the stock market, this is reflected in a significant resurgence of interest in cyclical and value stocks, which have considerable upside potential.
From this perspective, the UK equity market – as measured by the FTSE 100 Large Cap Index – has particularly attractive characteristics: since the vote for Brexit on 23. June 2016, the UK market has been neglected by international investors. But U.K. assets have been experiencing a downturn since the hard-negotiated deal with the EU signed at the last minute on 24. December 2020 a strong comeback. "The reason: the political risk premium is dissipating. This is evidenced by the fact that sterling is the fastest growing currency in the G10 this year against both the US dollar and the euro", Bonaviri explains.
Attractive underlying characteristics
Since the low point of the Covid 19 stock market crisis in March 2020, the UK index has accumulated a significant 20% performance gap to Eurozone equities due to fears of a hard Brexit. The result has been a significant valuation discount to global equities – the widest in more than 20 years. This makes the UK market the cheapest of the developed countries, the expert said. Statistically, the FTSE 100 shows almost twice as much sensitivity to the value factor as to the growth factor, he said. This, he said, is unique within the main indices.
However, the case for tactically overweighting the UK market is not limited to valuation considerations. UK stocks also have the highest dividend yield of any market at 3.8%. EPS growth expectations for 2021 are 49%, outperforming the U.S. (22%), eurozone (29%), Japan (46%) and emerging markets (39%).
An index adjusted to the macro environment
As Bonaviri goes on to point out, the cyclicality of the FTSE 100 stems from its sector composition. It is another particularly interesting feature of the UK index. With a 19% weighting in financials, which benefit directly from a rise in interest rates, and 21% in commodities such as energy and basic materials, the U.K. market is particularly well suited to the reflationary environment, says the senior portfolio manager. Including the industrial and consumer cyclical sectors, which are also very sensitive to the economic recovery, more than 60% of the FTSE 100 index should benefit from the economic recovery.
A bet on the recovery after Covid
The UK is one of the countries hardest hit by the pandemic, forcing the government to take unprecedented restrictive measures. They have led to a decline in GDP of more than 10% in 2020. However, England is the third most advanced country in the world in terms of vaccine deployment, with 30% of the population having received a first vaccination by the end of February 2021. "This suggests that the economy is rebounding ahead of most European countries and that a spectacular economic recovery is underway. The UK also has the highest expected average GDP growth over 2021-2022 among the G10 countries", Bonaviri notes.
The risk of a pound appreciation
However, this favorable scenario for UK equities is not without its frictions, according to the senior portfolio manager: The reflationary environment could push up interest rates and lead to a possible further appreciation of the pound. With nearly 80% of the FTSE 100's revenue generated overseas, a sterling appreciation could weigh on multinationals' earnings and earnings revision dynamics. "However, even though the relative performance of the FTSE 100 is strongly linked to the movement of the pound, we estimate the potential appreciation of the UK currency in the coming months after the impressive appreciation since 3. We expect the first quarter of 2020 to be marginal.", he adds.
Today – after more than five years of neglecting the UK market – global investors are still severely underinvested in the UK, he said. "Given the cyclicality of the FTSE 100, its attractive valuation and the expectation of earnings growth against the backdrop of a recovering economy, there is no shortage of catalysts that can drive capital flows into UK equities. In fact, since the beginning of the year, we have seen a rapid increase in the assets of FTSE 100 ETFs. This is evidence that the redeployment into British stocks had already begun", says Bonaviri.