The UK stock market is now looking “incredibly undervalued” after two years of being avoided by investors over Brexit concerns, fund managers focusing on the country agree.
Since the UK voted in the summer of 2016 to depart the EU, the country’s stock market has lagged its international peers by a significant margin. Other linked issues, such as the risk of a left-wing populist government led by the Labour Party’s Jeremy Corbyn, have caused investors to avoid the UK for much of the past two years.
FE Analytics shows that the FTSE All Share has posted a 17.51 per cent total return since the Brexit referendum on 23 June 2018; this is significantly below the 41.74 per cent made by the developed market-focused MSCI World index.
Performance of indices since Brexit referendum
Source: FE Analytics
This wide margin of underperformance has led some investors to expect the UK to bounce back in 2019.
Nick Mustoe (pictured), chief investment officer of Invesco Perpetual, focuses on valuations and, in his 2019 global outlook, noted that the US looks expensive relative to history but other areas – including the UK – appear more attractive. 
“As such, I am more constructive on the prospects for European, UK, and Asian markets over the next few years in regard to their ability to generate returns,” Mustoe said.
“Given the concerns around Brexit, the UK stock market looks incredibly undervalued. A lot of UK-domiciled stocks are trading at very low valuations relative to their global peers, suggesting that much of the ‘bad news’ has already been priced-in.”
Steve Davies, manager of the Jupiter UK Growth fund, also finds the heavy discount in the UK market to be an understandable but attractive situation.
“The UK is still deeply unloved by global investors,” he said. “In one sense, that attitude is perfectly understandable given the political and economic uncertainty affecting the UK, but it also means that there are some very lowly-valued stocks on the market.”
This uncertainty was highlighted last week after prime minister Theresa May survived a vote of no confidence. May is set to return to Brussels in a bid to win concessions on her Brexit deal, which has been criticised by some in the Leave camp.
“There is still no clear view on the shape of the future relationship between the UK and the EU once we leave the trading bloc on 29 March,” Davies said.
Performance of Cboe’s Brexit 50/50 indices since referendum
Source: FE Analytics
“We do know any deal must be sanctioned by Parliament but there is no certainty the current government will be in a position to put one forward that MPs will be prepared to approve.”
In light of this, the manager has been tactically reducing Jupiter UK Growth’s exposure to UK domestic companies such as housebuilders and banks and adding to international businesses that should perform well were sterling to fall sharply because of a ‘no deal’ Brexit.
The chart above shows how domestic companies (Cboe Brexit High 50) have performed relative to more international businesses (Cboe UK Brexit Low 50).
However, Davies added that this positioning could easily be reversed if the Brexit risk materially reduces: “In that environment there is potential for the unfashionable domestic UK stocks held in the fund to receive a significant positive reappraisal by the market.
“In our view, some of these stocks are trading at less than half of what we consider ‘fair value’, so the upside from almost any sort of Brexit agreement could be very substantial.”
Sue Noffke, manager of the Schroder Income Growth investment trust, pointed out that the underperformance of the UK domestic-focused companies has led to an attractive dividend yield across the market.
“When I look at the dividend yield of the UK stock market at 4.5 per cent I see it's at an equivalent level to that seen before and after the peak of the global financial crisis in 2008/09. However, I don't believe we are likely to see a recession in the order of magnitude experienced following the crisis,” she said.
“If we do see a recession, I would expect it to be local to the UK – possibly the result of a ‘no deal’ Brexit – rather than global, albeit world economic growth looks set to moderate in 2019. This gives me a degree of comfort that this elevated yield is sustainable, rather than a signal of impending distress, as the large majority of UK stock market dividends derive from overseas.”
Noffke added that the short-term outlook for underlying UK dividend growth has improved because of a strengthened pay-out ratio resulting from rising commodity and oil producer profits. Meanwhile, the banking sector, which is the other big driver of UK dividends, is “finally returning” to form 10 years after the financial crisis.
Source: Citi, October 2018
Should the UK avoid a ‘no deal’, she concluded, there would likely be an upwards movement in sterling and a re-rating of the market. This would be particularly beneficial to UK domestic companies that have suffered a de-rating since the referendum, such as UK-focused banks, property companies, housebuilders, consumer discretionary areas, food retailers, media agencies and utilities.
But Karen Ward, chief market strategist for Europe, Middle East & Africa at JPMorgan Asset Management, warned that because of this UK investors face “the greatest conundrum” if the current Brexit impasse is resolved. While any certainty would be good for the economy, it would challenge the international-facing companies that many investors have rotated into.
She explained: “Given that 73 per cent of FTSE All Share earnings are made overseas, UK investors will also need to bear in mind the potential implications of a positive Brexit outcome, which would be likely to result in higher sterling, hitting repatriated earnings for large-cap UK companies, even if they look attractive from a dividend yield perspective.”