Time for UK stocks to look beyond Brexit relief

Chris Hughes

Investors bought the Brexit deal rumor, and they mostly kept buying the news too. The 11th-hour agreement as 2020 drew to a close gave the “Buy British” trade yet another jolt forward. The investment case for U.K. stocks must now rest on more than simply relief that a chaotic split from the bloc was averted.

The pound moved 3% higher versus the dollar and euro between Dec. 11, when Brussels and London both warned an accord might not happen, and the end-of-the-year orderly breakup.

The U.K.’s main FTSE-100 benchmark dipped slightly in that period: The index’s historically strong inverse relationship with sterling, a function of its predominantly international earnings mix, may now be reasserting itself.

The FTSE-250 index of mid-cap stocks gained 4%. Across both indices, domestically-focused cyclical stocks simultaneously exposed to the currency and expectations for a post-pandemic recovery gained about 8%. These predictable dynamics continued a trend in evidence since late September, fueled by faith in a Brexit deal, optimism for vaccines and investors’ new enthusiasm for stocks offering exposure to a near-term economic bounce or ones that are simply cheap on conventional valuation metrics.

In both of Britain’s main stock indices, firms with a domestic focus comfortably outperformed the broader U.K., US and European markets in the last quarter of 2020. Investors had mostly been betting the U.K. and Europe would reach a compromise.

That basic view ought to be priced into U.K. assets now. While dollar weakness may make sterling look strong against the greenback, a more fundamental enthusiasm for the pound surely depends on the detailed implementation of the new trading agreement.

The other critical factor is at what point a largely locked down British economy can substantially reopen. As the new year begins, the health crisis is worsening in the U.K. and elsewhere. Restrictions appear set to get tougher before they are eased.

After their recent gains, U.K. stocks still don’t look expensive relative to other markets and many sit well with the broader theme of a rotation from pricey growth to cheap cyclical sectors.

About one hundred stocks across the FTSE-100 and FTSE-250 indices generate at least two-thirds of their sales domestically, with sectors including housebuilders, financials, capital goods and media accounting for about half of these, according to data compiled by Bloomberg.

That subgroup has a median average valuation of just 11 times forecast earnings for 2022, although in the current circumstances profit estimates that far ahead should be taken with caution.

For now, it makes sense for U.K. assets to trade at some discount given the uncertainty of the nation’s new relationship with the EU and the particular vulnerability of its services-based economy to the pandemic. But clarity could see the gap narrow. Smoke signals from Brussels moved U.K. assets in 2020. Hereon, investors should focus on the progress of vaccine distribution and the reality of Brexit.