The UK stock market has had a poor start to 2018. It has under-performed global markets for much of this decade, with the gap widening after the June 2016 Brexit vote. The new transition deal between the UK and European Union removes some uncertainty around Brexit but provides no relief for UK stocks, in our view.
The chart below shows the weak performance of UK stocks relative to other developed markets. The under performance is even starker in U.S. dollar terms – partly the result of a hefty sterling depreciation that gained steam in the wake of the Brexit vote.
The British pound has regained some strength over the past year, weighing on the international earnings of UK-listed companies. The composition of the UK market is another reason for its recent lagging. UK large cap indexes have a relatively high weighting to sectors that have underperformed in the past year, such as consumer staples and energy. And UK’s tiny technology sector has also hampered performance relative to major or global indexes offering hefty tech exposures.
Brexit-related uncertainties are part of reason for the UK’s relatively poor equity performance. UK growth has lagged that of its major economy peers over the past year. More UK companies cited consumer weakness in the fourth-quarter earnings season, while UK investment growth is soft relative to other markets. UK stocks have traded at a bigger discount to their global counterparts since the Brexit vote. The UK financial sector – a large part of the UK market – is extra sensitive to Brexit issues given the potential for reduced access to the EU.
The conditional transition agreement reached between the UK and EU last week, including a 21-month transition period, significantly reduces the risk of a disorderly UK exit from the EU next year, in our view. Our BlackRock Growth GPS indicator shows UK growth failing to take part in the global growth pickup and is the weakest in the G7. The gauge may start to reflect improved UK economic activity resulting from greater Brexit clarity, but the recent deal appears unlikely to be a catalyst for a recovery in the UK stock market. The end state of UK-EU relations is highly uncertain, with potential for a new cliff edge risk at the end of 2020. UK hopes that the EU will allow a bespoke trade deal appear overly optimistic, but we expect both sides to soften their tough stances as the negotiation deadline looms.
The reduction of near-term Brexit risks and a relatively hawkish Bank of England have supported the pound. We could see the currency rise further if issues surrounding the UK’s land border with EU member Ireland are sorted out. Yet sustained sterling strength would likely require UK growth catching up with that of other major economies.
We see UK earnings growth trailing its global peers and believe returns will be driven by earnings rather than valuations. Within the UK, we prefers companies where we expect strong earnings growth, particularly those with exposure to the U.S. and emerging markets.