Investors concerned about a slowing UK economy shouldn’t allow themselves to be put off the domestic stock market, which remains home to a number of international names, according to Hargreaves Lansdown’s Laith Khalaf.
Since the EU referendum in June 2016, a Brexit-shaped cloud has been cast over the outlook for the UK economy as the future relationship with the bloc – its largest trading partner – remains uncertain.
The lack of a deal just under two months before the scheduled exit date – 29 March – is reflected in the economic figures: the latest data from the Office for National Statistics showed that the UK economy grew by just 0.2 per cent during the final quarter of 2018, below Bank of England forecasts.
Source: Office for National Statistics
Meanwhile, capital expenditure fell for the fourth consecutive quarter – the first time since 2009 and the height of the credit crisis – as businesses have become more cautious ahead of the departure date.
That has worried investors, with the UK market emerging as the most underweighted region by international asset allocators, according to the latest Bank of America Merrill Lynch Global Fund Managers Survey.
“The UK economy is slowing, and no-one needs three guesses why – the continued political deadlock over Brexit is damaging business investment,” said Khalaf, senior analyst at Hargreaves Lansdown.
“Add in a weaker global outlook too, and you have a pretty unpleasant cocktail of economic news.
“This is clearly concerning for investors, though it’s important to recognise the economy and the stock market are two very different beasts.”
Khalaf said the UK stock market is made up of internationally diversified companies and is also forward-looking, so weaker expectations for economic growth are already largely factored into prices.
Yet since the vote, the blue-chip FTSE 100 has significantly lagged the developed markets-focused MSCI World index, with a total return of 24.26 per cent against the latter’s 45.77 per cent.
The analyst said investors should understand, however, that dips in economic performance and stock markets are “part and parcel of a normal financial cycle” and that a weaker outlook for the economy may not matter anyway.
“There’s actually little correlation between the performance of the UK economy and the UK stock market in any given year,” he explained.
“The chart below plots GDP against the return from the stock market in each year back to 1966, and the trend line shows there is close to zero correlation between the two, if anything there is a very slight negative correlation.”
Source: Hargreaves Lansdown
The analyst added: “Indeed, of the seven years in this period which have witnessed economic contraction, the stock market has risen in five.”
Some of this lack of correlation can be explained by the level of UK listed companies’ overseas earnings, which represent around two-thirds of revenues.
Another reason is the quick adjustment of stocks to changes in economic expectations, compared with official data.
“As such,” he said, “a slowing UK economy is already factored into market prices. These can still change of course, based on a further deterioration, or improvement, in expectations. For the UK, the Brexit outcome will play a big part in forming these expectations.”
However, with Brexit uncertainty continuing to drag on and broader macroeconomic and geopolitical concerns, some experts have asked whether the FTSE 100 could be due a further fall.
“The FTSE 100 currently stands above 7,000, which may lead some to believe it’s expensive, as this was the level it almost reached in 1999, at the height of the tech boom,” Khalaf said.
“This view doesn’t hold weight though, as the FTSE 100 is a price-only index and doesn’t take account of the earnings of UK companies, which are a critical factor in determining its value.
“Factoring earnings in, the UK stock market looks somewhere near the middle of its historical range, even on the cheap side according to some indicators.”
On its own preferred measure – the cyclically-adjusted price-to-earnings ratio (CAPE) – the Hargreaves Lansdown analyst said the UK stock market stands at 16.5x compared with a long run average of 19.3x.
“This signifies the market is on the cheap side, but not compellingly so,” he said, adding that “a more persuasive buying signal” for UK equity markets is the dividend yield on offer.
“At 4.3 per cent, it’s close to the highest it’s been since the financial crisis – having hit 4.5 per cent at the beginning of the year, and fallen back slightly as markets have rallied.”
Valuation measures, Khalaf said, suggest that the UK stock market “is reasonably valued at present, neither extremely cheap nor expensive”.
“In the short term it could go up or down without defying the laws of statistics, but for investors the motivation for putting money in the stock market remains its long-term potential, particularly when compared with cash,” he added.
Performance of indices since the EU referendum
Source: FE Analytics
As such, investors should not allow short-term moves to de-rail their long-term savings goals, particularly when it comes to trying to make post-Brexit predictions.
“Investors can’t control the direction of Brexit, or the economy, though they do need to consider where their money is best placed for the next 10 years and beyond,” he said.
“Indeed, if the economy is stalling, that’s not going to persuade the Bank of England to raise interest rates any time soon, so cash savers could find themselves facing a longer wait before their returns are beating inflation.
“Brexit is likely to continue to dominate headlines and sentiment towards UK shares for the foreseeable future, so investors need to step back and take a longer-term view.”