These are turbulent times for the global economy. The war in Ukraine has fueled sharp increases in oil and commodity prices, talk of stagflation is rife, and central banks are responding by tightening monetary policy. Against this backdrop, it is hardly surprising that global equity markets have struggled, with most major equity market indices posting losses year to date. And yet, despite the fact that the UK economy faces a particularly challenging outlook (see our commentary of May 2022), the main index of the 100 largest UK listed companies is one of the few that has notched up positive returns so far this year.1
How can this be the case?
The stock market is not the economy
The first point to note is that the performance of a country’s equity market does not necessarily reflect conditions in the domestic economy. Many large, multinational companies (e.g., Shell, BP, GlaxoSmithKline, Rio Tinto, HSBC, Unilever etc.) that derive their sales from all around the globe are listed in the UK. As a result, around three-quarters of the revenues of the UK’s largest 100 listed companies originate from overseas2.
In turn, this means that earnings for these companies are heavily influenced by trends in the foreign exchange market. For example, if the pound depreciates against the US dollar, this means that overseas dollar earnings, when converted into sterling, are worth more. This is what has happened this year, with the pound falling by about 7% against the greenback since the end of 20213. As a result, rising earnings in sterling terms have provided a key support for the UK market this year.
Sector composition
Another factor that has worked in the UK market’s favour has been its sectoral composition. Compared to its peers, the UK market has a relatively large weighting to energy and mining (or basic materials) companies, which have benefitted from this year’s sharp run-up in commodity prices. Companies operating in these sectors make up around a quarter of the UK index, compared with an equivalent weighting in the US of around 8% and in the eurozone of around 12%4. By way of example, even with the headwind of the recent windfall tax, the share price of BP is still up around 30% so far this year5.
In addition, the UK market has a relatively large exposure to companies that provide goods and services that households are less likely to cut back on when times are hard. People whose incomes are being squeezed are more likely to cut back on their Netflix subscription or forgo a new phone rather than go without food or medical items for example. So-called ‘defensive’ equity sectors (such as consumer staples, utilities and healthcare) tend to do well when investors are concerned about the economic outlook and contrast with ‘cyclical’ sectors (such as industrials and consumer discretionary), which generally outperform when growth is picking up.
According to Schroders, the fact that energy and defensive sectors combined make up about half of the UK equity index means that it is well placed to outperform during ‘stagflationary’ episodes (i.e., when inflation is elevated and growth is slowing) as is the case currently. This finding has been borne out this year, with these sectors generally outperforming their cyclical counterparts at the global and UK level6.
As well as having a relatively high exposure to sectors that have outperformed this year, the UK has also benefitted from a low weighting to the tech sector, which has suffered a brutal sell-off in recent months. Tech/internet companies with high valuations based on the expectation of strong future profits have been hit particularly hard by rising interest rates and bond yields. This is because rising bond yields make a company’s cash flows in the distant future worth less today due to higher discount rates. At the global level, tech has been one of the worst-performing sectors this year, registering a fall of around 20%7. As tech accounts for less than 1% of the main UK equity index8, this ‘derating’ of so-called growth stocks has been less of a drag on performance.
A sustainable outperformance?
All of this begs the question as to whether the recent outperformance of UK large caps can continue. Given the reasoning outlined above, one factor that could weigh on the UK’s relative performance would be a renewed strengthening of the pound. Trends in exchange rates are notoriously difficult to predict, but given the UK’s near-record trade gap and the stagflationary outlook, it is hard to see the pound staging a significant appreciation during the coming months. Indeed, the threat of renewed tensions with the European Union over the Northern Ireland Protocol could add to downward pressure on sterling.
A shift in global equity sector leadership would also carry the potential to weigh on relative performance. Most obviously, a levelling out or a pull-back in the oil price could halt the recent outperformance of the global energy sector from which UK equities have benefitted. Increased supply (perhaps resulting from a de-escalation of the war in Ukraine or a deal with Iran/Venezuela) could take the pressure off prices. The recent re-opening of the Chinese economy following stringent covid lockdowns has supported commodity prices recently, but Beijing’s zero-covid policy raises the prospect of more disruption on this front.
A cyclical rebound in the global economy would also diminish the appeal of the defensive equity sectors that make up a disproportionate share of the UK large cap market and have performed relatively well this year. However, with household incomes under pressure and central banks around the world looking to slow the economy in order to rein in inflation, the chances are that the economic data flow will get worse before it gets better. Leading indicators such as business confidence and orders/inventories ratios in the manufacturing sector do not provide much hope for a near-term cyclical upswing9. This suggests that the preference for defensive equity positioning amongst investors could be maintained for a while yet.
Relative valuation
As regards valuations, even after their recent outperformance, UK equities are still relatively inexpensive, trading on a forward price/earnings (PE) ratio of around 11 versus a figure closer to 16 for their developed market peers. Although lower valuations in the UK are a reflection of a lack of exposure to more highly-valued ‘growth’ companies, calculations from JP Morgan suggest that the UK is still relatively attractive even on a sector-neutral basis.
Compared with other asset classes, rising bond yields have somewhat diminished the relative attractiveness of UK equities. However, the current UK dividend yield of 3.7% still exceeds that of the 2.5% yield on the 10-year Gilt by 120bps, and the spread is still above the average gap of 60bps since 200010. Moreover, with corporate revenues in part driven by trends in nominal GDP growth, UK equities at least hold out the prospect of generating inflation-beating returns over the longer term, whereas the prospective returns on UK government bonds are likely to fall short.
Sure enough, financial markets are likely to remain volatile given the economic outlook. And if tighter monetary policy and squeezed household incomes push the global economy into recession, it is unlikely that any regional equity market or equity sector will emerge unscathed. However, UK equities are proving to be a relatively good place to shelter during turbulent times and a useful component of a diversified portfolio.
13th June 2022
1 FE Analytics
2 JP Morgan -Equity Strategy Chartbook, June 2022
3 https://tradingeconomics.com/united-kingdom/currency
4 FTSE, MSCI Factsheets
5 https://www.londonstockexchange.com/stock/BP./bp-plc/company-page
6 FE Analytics
7 FE Analytics
8 FTSE Factsheet
9 https://ihsmarkit.com/research-analysis/headwinds-stifle-developed-world-expansions-in-may-May-22.html
10 https://tradingeconomics.com/united-kingdom/government-bond-yield#:~:text=The%20United%20Kingdom%20Government%20Bond%2010Y%20is%20expected%20to%20trade,3.10%20in%2012%20months%20time JP Morgan, Equity Strategy Chartbook, June 2022