The United Kingdom, neglected for years by investors, is set to have the worst economic performance among major economies. But its outlier status may create opportunities, especially if things don’t turn out as badly as many predict.
The International Monetary Fund sees the U.K.’s economy contracting in 2023, the only Group of Seven economy to do so. It’s one of two advanced economies that has yet to recover the output lost since the start of the Covid-19 pandemic—the other being Russia. And the Bank of England predicts the nation will spend much of the coming year in recession, even as it continues to raise interest rates.
The country’s bleak economic prospects have fed through to stocks. Companies on the FTSE All-Share index trade at a low 10 times earnings on average. The S&P 500 trades at about 18 times earnings. Germany’s DAX at 13 times, Japan’s Nikkei at 16 times.
That discount for the U.K. is larger than usual, according to Frederique Carrier, head of investment strategy at RBC Europe. One thing to note is that U.K. stocks never really covered from the pandemic—the FTSE is up less than 4% since the end of 2019, the S&P trades 28% higher.
That suggests some room for catch-up. Similarly to the U.S., stocks have been rising of late—the FTSE All-Share is up more than 8% in the past three months, compared with just 4.3% for the S&P.
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“Low valuation levels compared with the U.S. warrant some positioning in the U.K. and Europe for a globally diversified portfolio,” said Carrier. “However, we would be selective and wouldn’t chase the rally.”
There are several reasons why the U.K.’s outlook is seen as poor. One is its exposure to natural gas. After Russia’s invasion of Ukraine last year prices were soaring, and on top of that the U.K.’s capacity to store natural gas is much worse than, say, Germany’s. That makes it more vulnerable to swings in spot prices.
Another issue is that interest rates are moving higher than in the rest of Europe, and the housing market is vulnerable. Third, the decision to leave the European Union in 2016 has depressed business investment ever since, and it has yet to recover.
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But there could be further opportunity if those things could prove to be less harmful than feared, according to ING economist James Smith.
Gas prices have dropped and the winter has been mild.
The Bank of England is one of the first to signal it could soon stop raising rates, and the rate increases so far haven’t really hit mortgage borrowers yet because many of them are on fixed-rate deals and don’t need to refinance right away.
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Put those two together, along with the fact that unemployment rates remain historically low and inflation is slowing, and consumer spending could be stronger than anticipated, making some retailers and travel firms attractive.
“We’ll probably get a very mild recession, but nothing to really write home about,” said Smith.
Investors may want to consider taking a chance on consumer-facing stocks to take advantage of any surprises. Online retailer ASOS (ticker: ASC.LONDON) has taken a beating in the past year, down 57%. But it’s up more than 60% since Jan. 1. The company has a market capitalization of £832 million ($1 billion) and trades at 27 times earnings, valuing it at a 70% premium to its peers.
Or there’s car maker
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(AML.LONDON), the favorite ride of fictional special agent James Bond. It’s down more than 50% over 12 months, but has recovered almost 30% this year so far. It has a market value of £1.4 billion
Online travel booking group Hostelworld (HSB.LONDON) is up 20% this year, and would stand to benefit if U.K. consumers have extra money in their pockets this summer. It trades at 30 times forward earnings, a premium to its peers.
The consequences of Brexit, which include the slump in investment as well as making it harder to trade with the U.K.’s biggest partner, may be harder to avoid than the hurdles from gas prices and interest rates. But the U.K. does seem to have achieved a bit more stability under Prime Minister Rishi Sunak.
He took over after his predecessor Liz Truss had to resign after only a few weeks on the job, having sparked market turmoil with a program of radical tax cuts that investors judged would worsen inflation. That sent the pound down to a record low against the dollar at around $1.03. It’s since recovered to above $1.20.
“We’ve been bottom of the pack in terms of business investment, and that will weigh on our capacity to grow,” said ING’s Smith. “But I’m not so sure about the story the IMF was selling about the U.K. having such an awful performance.”
Write to Brian Swint at [email protected]
