The recent selloff in gilts and sterling has left some sectors of the UK stock market trading at levels last seen in 2023, reinforcing the perception that London is a market global equity investors can safely ignore. It’s hard to see a speedy and likely path out of the mire.
The stock market’s reaction to rising borrowing costs and a declining currency has been textbook. The FTSE 100 blue-chip index, dominated by multinational companies generating revenue from overseas, has held its own. As Goldman Sachs Group Inc strategists point out, sterling weakness should be supportive.
On the other hand, stocks with bond-like characteristics have tumbled — notably real-estate firms whose value is tied to the yield provided by their rental income. Housebuilders face slower revenue growth if pricier mortgages deter home buyers. UK companies that make their money in their home market and buy supplies from abroad will feel the squeeze from the exchange rate. That applies to much of the FTSE 250 mid-cap index.
The dynamics are reinforcing existing concerns about the prospects for these and other domestically focused sectors that took hold late last year. Before worrying about US Treasury yields, investors were fretting about UK Chancellor of the Exchequer Rachel Reeves’ business-unfriendly budget, which jacked up payroll taxes for employers. The FTSE 350 retail and real estate investment trust sectors have fallen more than 20% from third-quarter highs. FTSE 350 housebuilders are down more than 33%.
It is a bittersweet situation for contrarians and value investors. The lure to buy is clearly there. Morgan Stanley strategists say domestically focused UK stocks that are sensitive to gilt yields trade at forecast-earnings multiples close to recent historical troughs. Goldman argues that the UK market is “especially cheap versus history” at a time when US stocks are “priced for perfection.”
Suppose well-targeted government spending, planning reform and wage increases can stimulate the housing market — that would also have a ripple effect across the economy and corporate earnings.
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But there are so many variables in the equation; for starters, the trajectory of US rates. As Morgan Stanley’s team points out, rate-sensitive UK mid-caps may trade like proxies on both UK and US yields and respond to related data. The global inflationary picture needs to become clearer. Then there’s the question of what else could catalyse a reversal of the downward trend. Cuts to the UK base rate would stir interest but the Bank of England may be constrained from sizable moves absent revisions to the government’s budget measures. Ultimately, the UK needs to deliver convincing economic data and corporate earnings growth.
This all takes place against a backdrop of an already challenged UK stock market, which represents a fraction of the equity universe. The absence of meaningful ownership by domestic pension funds deprives international investors of a buy signal from those who should have the advantage of familiarity with management and UK companies’ home market. Small and mid-cap stocks suffer from thin trading. Institutions making a big bet on some of these downtrodden plays risk struggling to exit their position without a chance to sell in a takeover bid.
Reeves is, of course, already trying to address these structural issues. But the task of making London great again has gotten harder. — Bloomberg Opinion
