Brexit will remain a constant shadow over UK equities across the course of 2018, fund managers are united in pointing out, although there are signs that this is leading to compelling value opportunities in the domestic market.
Investors have been cautious in their outlook for the UK after the country voted to depart the EU, with many in the City forecasting a period of economic weakness and political uncertainty.
The latest edition of the Bank of America Merrill Lynch Global Fund Manager Survey found that asset allocators across the globe are reluctant to invest in the UK. In December, the closely watched survey reported a net underweight of 34 per cent to the UK stock market among the 172 fund managers who were polled; this “severely depressed” sentiment is close to lows seen during the financial crisis.
Over 2017, the FTSE All Share has remained in positive territory and posted a return of more than 10 per cent between the start of the year and 19 December. However, as the chart below shows, this was lower than the gains made by the index’s international peers.
Performance of indices over 2017-to-date
Source: FE Analytics
But some argue that the underperformance of the past two years could have left the UK in an attractive position in a world of generally stretched valuations. Chris Burvill, manager of the Janus Henderson Cautious Managed fund, noted that 2018 is likely to be a “seminal year” for the UK given its post-Brexit future will be determined in the coming months.
“With the UK market as universally out of favour as it is now, any move towards a more accommodating relationship with Europe could, from here, have a disproportionately positive effect on both sterling and UK equities,” Burvill said.
“At the risk of repeating our mistaken call this time last year, we stick to the view that the UK provides one of the few remaining compelling investment prospects for the year ahead. Very few other markets hold that combination of low valuations, low expectations and clear opportunity for reassessment, possibly in the very short term.”
The manager highlighted domestic-focused companies such as financials, those dealing with the consumer and groups exposed to government contracts as the sectors showing the greatest opportunities, but added that many exporters and overseas earners have also been caught up in the sentiment collapse.
“We have now reached the point that all these sectors have scope to perform well next year even without an improved political landscape,” Burvill added. “But we might be wrong.”
Steve Davies, manager of the Jupiter UK Growth fund, agreed that Brexit will remain the key issue for the UK in 2018 but sees a much more complicated outlook. He described the range of outcomes for the UK stock market in 2018 as “unusually broad” and depends on the rate of progress made in the Brexit negotiations.
At one end of the spectrum, the pound could rally, economic growth pick-up as inflation subsides and business confidence improve if a transition agreement can be secured early in 2018.
“Paradoxically, the FTSE 100 index may struggle to make any progress in these circumstances, as many of its constituents are global businesses whose earnings would be hit by the rise in sterling,” he added.
“On the flip side, any company exposed to the UK domestic economy (such as banks, retailers, housebuilders, travel companies etc) could be re-rated by up to 30 per cent, in my opinion. International investors have largely given up on UK domestic earners over the last 18 months, with sentiment arguably as negative as it has been since 2008, so any positive political catalyst could have a dramatic impact on valuations that are now extremely low by historical standards.”
Performance of FTSE All Share sectors over 1yr
Source: FE Analytics
The opposite end of the spectrum, however, would be inadequate progress in the Brexit talks leading to an increased likelihood of a hard Brexit on World Trade Organization terms in March 2019. As this approached, so would the risk of Theresa May’s government collapsing and another general election being called, with the possibility of Jeremy Corbyn being elected prime minister.
“I believe a fall in the pound and a further slowdown in GDP growth would likely follow and domestic earners on the stock market would continue to struggle while multinationals and dollar-earners would outperform,” Davies concluded.
“The chances of such an outcome have clearly decreased due to the progress that has already been made in Brexit talks, but that does not yet mean it can be discounted completely.”
David Coombs, head of multi-asset investments at Rathbones Unit Trust Management, believes that the risk of a Corbyn government is one that investors need to be particularly cognisant of as we move into 2018.
Corbyn’s anti-capitalist rhetoric has led to the Labour leader being viewed as bad for markets. A recent note by analysts at Morgan Stanley said a Corbyn government could be the “most significant political shift in the UK” since the election of Margaret Thatcher and could potentially be a “bigger risk than Brexit” to the economy.
In response, Corbyn said the financial sector was made up of “speculators and gamblers who crashed our economy”, warning that he would be a “threat” to global banks if he became prime minister.
Coombs said: “The fragility of this government means there is a real threat that it could collapse, opening the way for Jeremy Corbyn’s Labour to take power in an early general election. The chances of this seem slim, but the potential effects are worrisome enough to keep this risk high up in investors’ minds.
“If Mr Corbyn were to become prime minister, we believe gilt yields would rise and sterling would fall dramatically as foreign investors may abandon UK assets wholesale. Domestic equities would be hit hard, both by rising import costs and a fall in businesses’ appetite to invest (hitting economic growth). The ultimate result could be stagflation. If an election were called, we would avoid UK assets with extreme prejudice.”
Mark Martin, manager of the Neptune UK Mid Cap and Neptune UK Opportunities funds, said politics is one of the three key issues that UK investors should be watching in 2018 but added that it is not the only thing that will impact the stock market.
The FE Alpha Manager pointed out that there is only limited scope for UK consumer confidence to improve much, which could hold back the more domestically focused sectors. Very low unemployment levels, weakening house prices, high consumer debt levels, rising interest rates and rising inflation are all reasons why consumer confidence is likely to stagnate.
“Although valuations are low for certain domestic cyclical stocks, we are continuing to avoid the broader sector,” he said. “Instead we are focusing on overseas earners and those domestically -focused companies that are exposed to non-discretionary spending within both UK funds.”
Another factor aside from Brexit that investors need to be aware of is the likely return of volatility. Recent years have seen a marked decrease in volatility measures across most asset classes, caused by multiple factors including ongoing ultra-low interest rates.
While Martin does not expect interest rates to increase materially in the UK, even a small rise in rates could cause consumer stress and increase volatility from its lows.
“Over the short term, low volatility can beget low volatility, elevated confidence and elevated asset prices. Over the longer term, however, low volatility can in fact beget higher volatility,” he said. “Investors should bear this in mind and invest on an appropriately long timescale.”
Jason Hollands, managing director of business development and communications at Tilney, said the UK stock market could be the “wild card” for investors in 2018 and investors should not ignore, even though the outlook is so dependent on the Brexit talks.
Tilney currently has a neutral position on UK equities and the consensus view is cautious because of the headwinds facing the economy and the many political uncertainties. However, as highlighted above, this could all change if good progress is made on Brexit.
“Companies heavily exposed to the domestic economy are certainly cheap and if a scenario plays out during the year that the UK and EU do make good progress towards a mutually agreeable future relationship, a lot of current anxiety could evaporate,” Hollands added. “That might see international investors return to the UK market with greater confidence, so it is certainly one to watch.”