Negative sentiment towards Brexit has driven UK equity valuations to levels not seen since the onset of the first and second world wars based on one valuation metric, according to JP Morgan Asset Management’s James Illsley.
Since the UK electorate voted to leave the EU in June 2016, the UK has lagged other global developed markets as uncertainty over its future relationship with the bloc troubled international investors.
Performance of FTSE All Share since UK referendum
Source: FE Analytics
Indeed, international investors have shunned UK stocks and moved to large underweight positions while domestic investors have also withdrawn money from UK equity strategies.
However, JPMAM’s Illsley, who is a co-manager on the £582.6m four FE Crown-rated JPM UK Equity Core fund, said pessimism over Brexit has been overdone.
“For a long period of time, post-Brexit, the UK equity market has been one of the most underweighted and unloved asset classes globally,” he explained.
“It reflects a lot of investors putting it into the ‘almost too difficult to analyse’ bucket and ignoring it to a certain extent.”
Illsley added: “More recently there is some tentative evidence that we’re starting to see some of that negativity abate.
“Most people who want to sell UK equities have already sold them, so the marginal trade from here will be people buying back in. We are after all the third largest equity market after US and Japan.”
The JP Morgan fund manager said there have been encouraging signs for the UK economy, while the political backdrop has also improved with an interim deal between the EU and UK seemingly agreed.
“You only have to look at the newspapers, Bloomberg or any commentary that Brexit is considered widely from an exit point of view,” he said.
“But, if you look beyond that, the UK economy has been performing surprisingly strongly for those that were worried about what might happen after the referendum.
“We’ve seen GDP forecasts recover post-referendum, not that far off where they were before [albeit] a little bit lower,” Illsley explained.
The JP Morgan manager noted that sterling had recently traded at £1/$1.43, similar to levels seen during the referendum campaign.
“That reflects sterling strength, and also dollar weakness, although against other currencies it’s not quite as strong,” he said.
“But the trend is there that the UK currency is starting to appreciate and you’re starting to see that in other areas of the economy.”
Performance of sterling vs US dollar since UK referendum
Source: FE Analytics
Elsewhere, unemployment has reached near 30-year lows and wage growth has started to outpace inflation.
“There’s quite a lot of things bubbling along under the surface which should be positive for the UK economy,” he added.
As such, the valuations now seen in the UK market are looking very cheap.
The JPM UK Equity Core fund manager said, based on dividend yield alone, UK equities have only been cheaper in 1914 and 1939.
He explained: “If you’re looking at the UK equity market it looks very cheap, the overall market itself yields over 4 per cent.
“Compare that with other equity markets globally, just that headline income attraction for the UK is very high.
“If you look at price/earnings or cyclically-adjusted price/earnings [CAPE] or cashflow you can make the argument on those grounds as well.”
Illsley added: “I know it’s an old way looking at the market, but if you were to look at the relationship of dividend yields at 4 per cent and 10-year bonds at 1.5 per cent, [there is] about 2.5 per cent yield pick-up in buying equities over the bonds.
“If you chart that back to the start of the last century there are only two times when that gap 2.5 per cent was bigger and that was in the first world war and second world war.”
He said: “Irrespective of the view of Brexit, I would argue that the outlook isn’t as bad as it was in 1914 and 1939 and yet the disparity in valuation between equities and bond is as great as it was in those two periods, which just shows the scale of negativity around UK equities and bonds.”
As such, the JPM UK Equity Core fund manager said there are a number of interesting valuation opportunities for those who take a positive or a negative view of the UK market.
For those with a more negative view of Brexit, among the large-caps can be found a number of strong businesses with greater exposure to international revenues.
“We know that the global economy has been well for a couple of years, so when you look at what’s worked well since the referendum it’s been led by the cyclical areas of the economy including commodities, industrial metals and engineering sectors,” said Illsley.
“And if you look at the global picture today you would still say its cyclical picture: the US and Europe are still performing well so there is scope for the commodities area to do well. The oil price is above $70 per barrel and the UK has a bigger weighting to oil [companies].”
He added: “Commodities and oil are areas we’re still positive on, driven by that supportive global backdrop. We like selected areas of engineering; it’s not a huge part of the index these days but there are high quality engineers and industrials that we’re overweight in and are continuing to do well.”
For those who take a positive view of wage growth and are more bullish on the UK consumer, there are some interesting companies to be picked up, albeit with the caveat of disruption in the sector.
“The structural change in how [consumers] shop and what they want to buy and the structural shift from high street to online, that’s challenging a lot of businesses,” he explained.
“That’s been overlaid with cyclical pressure we’ve seen in the past couple of years from post Brexit where inflation has been high and wage growth hasn’t kept up so we’ve had a squeeze in consumer spend seeing that second aspect start to reverse,” said Illsley.
“It’s about picking high street retail winners that should benefit from current consumer taste and that will continue.
“For us we’re looking at stocks that will benefit from those trends. If you think about JD Sports and the athletic leisure type of trend, that’s an area that younger generation are prepared to spend on in terms of branded and high-profile trainers.
“If you think about areas that appeal to the search for value, B&M European Value satisfies that and we look in terms of the travel sector and we have a number of low-cost airlines based in this country like International Airlines Group.”
The manager added: “We think cyclical pressures are abating in terms of that consumer but the structural clashes and need to identify the relative winners over the medium-to-long term continues as before.”
Illsley has been a manager on the JPM UK Equity Core fund since 2013 and oversees the fund alongside Christopher Llewelyn, Anthony Lynch and Callum Abbott.
The fund aims to provide capital growth and outperform the FTSE All Share index over the long term by investing primarily in a portfolio of UK companies.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
Over three years the JPM UK Equity Core fund has delivered a total return of 21.8 per cent, compared with a 20.18 per cent gain for the average IA UK All Companies fund and a 19.3 per cent return for the benchmark FTSE All Share index.
It has an ongoing charges figure (OCF) of 0.4 per cent.