Unlimited quantative easing, negative real rates and the coming US fiscal stimulus have investors on heightened alert for any sign of bubbles starting to burst.
Signs of them inflating appear everywhere, from the rise of bitcoin and the furore over GameStop to the proliferation of special purpose acquisition companies (Spacs).
One group of investors can rest easy though. There are few signs that financial valuations in UK equities have become disconnected from economic fundamentals.
In 2020, plentiful and cheap central bank liquidity led to a quick reverse of the March equity market crash in most markets around the world.
The FTSE 100 is the big outlier. It stands today at 14% below its 2020 peak
The S&P 500 fell from 3,337 in late February 2020 to 2,305 one month later. Today it has more than recovered to at an all-time high of 3,911. That’s 17% higher than it stood a year ago.
The German DAX index is 3% above its previous high last February. The EuroStoxx50 hasn’t done quite so well, being still 4.6% below its high last February.
But the FTSE 100 is the big outlier. It stands today at 14% below its 2020 peak, despite all the efforts of the UK Treasury to support businesses and the Bank of England to overcome the worst effects of the pandemic.
It is not hard to see why, even though UK policymakers don’t like to talk about it much.
Macro forces
“Were it not for the pandemic, Brexit would be a major focus for UK markets,” says John Wraith, head of UK and European rates strategy at UBS. “The pandemic is driving our own growth forecasts for this year and next.
“For good or ill, Brexit and the early adjustments the UK is making to it, have been masked by the stronger macro forces of the pandemic. But it has not gone away just because it’s not being talked about.”
Actually, Brexit is being talked about a lot, even if market strategists and Bank of England officials are not leading on it. In the second week of February, the British Meat Processors Association (BMPA) reported that consignments of British meat heading to Europe are 50% below normal volumes.
The pandemic is driving our own growth forecasts for this year and next
John Wraith, UBS
Nick Allen, chief executive of the BMPA, explains some of the reasons for this: “The new system is adding an average of 30 hours into the process; and the costs to ship these loads are now around 60% higher than last year.”
He adds: “This is caused by a combination of additional charges from HMRC and their French counterpart, extra customs agents’ and veterinary charges to process the paperwork and haulage charges that have risen four-fold due to delays at the border.”
Of course, teething problems are the new ‘Project fear’.
There is much debate on whether or not the struggles of UK exporters and importers to cope with non-tariff barriers are more than an initial adjustment and could lead to permanent scarring on the UK economy.
Departure from the single market makes the UK less attractive for foreign direct investment by companies seeking to trade with Europe. Now, UK companies themselves are investing in European hubs, diverting spending and jobs from their home market.
At the February Monetary Policy Committee press conference, where the Bank of England held nominal policy rates at 0.1%, governor Andrew Bailey batted away questions on whether or not these struggles are more than teething problems.
“So far, I think it’s fair to say that, obviously, there’s a lot of evidence yet to come,” he said.
The Bank of England had nothing new to say on Brexit. This was all covered in its November 2020 projections.
Could the Bank of England be fearful that as intimidating a figure as Conservative MP and leading Brexiteer Jacob Rees-Mogg might accuse it of taking a political stance if it expresses a view on Brexit?
February’s 51-page monetary policy report does bury the finding that, in comparison with a frictionless arrangement, UK trade is projected to be around 10.5% lower in the long run under the new agreement with the EU; productivity and GDP are expected to be around 3.25% lower.
Long-term implications
UBS suggests that the UK’s decision in 2016 to leave the EU, accompanied by years of uncertainty around the future relationship, has already led to a 3.7% loss of GDP (or 1.25% a year) between 2016 and 2019.
And while the most damaging outcome of a hard Brexit may have been averted, the new regime is likely to have long-term implications beyond immediate adjustments in the first three months of 2021.
The Swiss bank sees UK GDP as likely to have fallen by 10.5% in 2020. It predicts a slower rebound this year than for most other G7 economies, of just 3.8% and then 5.8% in 2022. That leaves the UK likely to enter 2023 with a smaller economy than when it went into 2020.
“Brexit is still an issue in the UK that will see a rebound more muted than elsewhere,” says Wraith. “We see much weaker net trade, with exports and imports both negative this year and next compared to a 10-year average growth rate for each around 3%.”
UBS thinks the Bank of England is preparing for this even if it is not talking about it.
We have not seen all European financial institutions adjust yet
Michael Werner, UBS
The present timetable for Gilts purchases suggests it will be buying £4.4 billion a week well into the final quarter of 2021, even while projecting an easing from lockdowns and recovery from the worst effects of the pandemic from the second quarter.
Wraith says: “They tend to downplay Brexit concerns. But it’s pretty clear they have got one eye on frictions around Brexit and see a need for stimulus beyond the point where Covid is no longer an issue.”
UBS calculates disruption to services trade stemming just from non-tariff barriers could be equivalent to a tariff of anywhere between 6% and 26% depending on the sector.
In financial services, which makes up 6.5% of the UK economy, the next shoe to drop will be clearing of over-the-counter derivatives, where the EU has granted a third round of temporary regulatory equivalence recognition to UK providers, while encouraging European financial institutions to switch away from them.
In future, most euro interest rate swap clearing will migrate to the EU and dollar swap clearing to the US.
“We have not seen all European financial institutions adjust yet,” says Michael Werner, head of European specialty financials equity research at UBS. “If equivalence is not rolled over, you will see euro denominated swap clearing fully migrate to the EU. I wouldn’t be surprised if that migration continues as we go through this year.”
Searching for value
And here we see the true magic of financial services at work. What does all this mean for investing in the UK? Why, it is great news of course. The UK market is not a bubble yet. So, this is the one to jump on before it inflates.
The kicker could be a speedier roll out of the vaccines in the UK than elsewhere, a rare example of the UK government managing to do something well. But the argument for buying UK stocks is the oldest one in the book: they are screamingly cheap.
We see international investors coming back to the UK, having been absent for a long time
Nick Nelson, UBS
Nick Nelson, head of European equity strategy at UBS, points out: “Performance since the Brexit vote [in June 2016] has been very poor, one of the worst among global equity markets. Valuations whether on price to earnings or price to book are close to 20-year lows.”
The UK equity market is dominated by unfashionable relics of the old economy: banks and energy companies.
Having pushed up technology stocks, of which the FTSE 100 has few, to uncomfortable levels, international investors are now searching for value.
“We see international investors coming back to the UK, having been absent for a long time,” Nelson says.
UBS sees the FTSE 100 hitting 7,200 by the end of 2021, while offering a 4% dividend yield to income investors. And it thinks Sterling can also regain some of its lost ground, recovering against the dollar from around $1.38 today to $1.47 by the end of this year, on the way to $1.53 in 2022.
That would take the currency back to where it stood in 2015 before the Brexit referendum.
Even though this is a dollar weakness story, it might make UK equities look even more attractive.
“There could be close to a 20% return for dollar-based investors,” says Nelson. “It is one of our most favoured markets globally.”
One word of warning. Many FTSE 100 stocks derive a lot of revenue from outside the UK, so dollar weakness might hurt their earnings. The search for more domestic-oriented stocks, less damaged by Brexit, leads more to the FTSE 250.
So, there you have it. The UK is a bit rubbish. And that’s why you should buy.
It is a bit like GameStop just before the short squeeze, only this time it is a country.
