Beyond Brexit: Emerging from the shadows

As Brexit negotiations intensify, James Goldstone reflects on the outlook for UK equities once the trading relationship with the EU is determined.

It has been four and a half years since the referendum and over that time Brexit has cast a long shadow over the UK equity market. However, with less than a month to go until the transition period expires, we are getting close to a conclusion which should lift some of the uncertainty that has clouded the UK equity market since 2016.

Indeed, the impact on the UK equity market of the vote to leave and the years of negotiations and missed deadlines has been significant. In terms of price, the UK equity market has significantly lagged every other major market since January 2016. Confidence in UK stocks has fallen so far that the market appears to be undervalued to such an extent that UK equities are trading at a significant discount to their 20-year average.

In contrast, the US, developed markets, emerging markets, and Asia ex-Japan markets are all trading at a premium to their long-term average. Japan and Europe ex-UK are trading close to their long-term average, while the UK is the real outlier with more than a 25% discount to its long-term average. On that basis, both relative to its own history and to international markets, I believe that the UK equity market presents a very attractive valuation opportunity.

In fact, the valuation of every sector of the UK equity market is lagging its US equivalent relative to its own 20-year history (see Figure 1). Domestic-facing stocks have certainly come under the most pressure, but other areas that are lagging include sectors which are almost entirely focused on international markets and/or exposed to international growth trends.

Fiqure 1: Valuation relative to 20 year average – UK vs US

In the left-hand column (overall market) we can see that the US is significantly expensive (2.6 standard deviations) relative to its own history. By contrast, even though we are at trough levels of economic activity, the UK still looks cheap (0.3 standard deviations) relative to its own history.

The overall difference in these two measures speaks to the substantial value in the UK equity market compared to the US (the difference is currently just under 3 standard deviation points). Significantly, relative value versus history is found in the UK across all ten of the major sectors. The cheapness of the UK equity market is therefore not just in stark contrast to the highly valued FAANGs. Value is widespread in unloved, high quality UK-listed names across all sectors.

Expanding this same analysis across a 20-year time scale, the overall valuation disparity between the UK and US markets becomes even clearer (see Figure 2), with the value opportunity in the UK currently at extreme levels.

Fiqure 2: Valuation relative to 20 year average – UK vs US

Closer inspection of Figure 2 shows that the origin of the valuation disparity is around the time of the Brexit vote. Since then, international investors have evidently shied away from investing in UK companies because of the added political uncertainties.

In fact, for many international investors, the whole of the UK equity market has effectively become ‘uninvestable’, though as a long-term investor with a valuation-driven approach, I believe that this extreme differential now represents a real opportunity.

The uncertainty around the UK’s future relationship with the EU has negatively impacted Sterling too. It has been volatile since the referendum, trading against the US dollar at around $1.50 on the eve of the vote, dipping to $1.15 when it looked like we might leave without a deal, and at this late stage in the negotiations is now trading at around $1.33 – in the middle of the range, suggesting that in the view of currency markets the outcome remains in the balance.

Should there be a deal with the EU, there would be significant upside for the UK equity market, on both an absolute basis and relative to international indices. Even in the worst-case scenario, a ‘no deal’ WTO Brexit, I think that this would be an attractive starting point in valuation terms.

Over the coming weeks, many of the uncertainties surrounding Brexit will become clearer – one way or another. If the negotiations do conclude with a deal, I would expect to see some upside to Sterling and renewed interest in the UK equity market from international investors. This would reflect growing optimism about the UK's prospects as we exit the EU and confidence in a UK and global economic recovery, driven by the emergence of several credible Covid-19 vaccines and the prospect of a workable trade deal with the EU.