Back in business
Recovery hopes are a shot in the arm for the UK stock market
The UK’s impressive vaccine rollout and subsequent dramatic fall in COVID-19 cases, as well as additional support measures announced in the Budget, are driving confidence that the government will manage to stick to its reopening plan. We believe this roadmap gives the country a fighting chance of seeing an early uptick in economic activity, at least compared to the rest of Europe, and should continue to provide a supportive environment for UK equities.
The past year has undoubtedly been challenging for the UK economy, which shrank by a record 9.9% in 2020. The country’s rapid vaccination programme has boosted recovery hopes, and the Office for Budget Responsibility has upgraded its forecast: it now expects the UK economy to recover to its pre-pandemic size by the second quarter of 2022 — six months earlier than it predicted in November.
We see scope for UK equities to outperform in the short term, as overseas investors who have fled the UK in recent years start to dip their toes back in. The pound could also continue to rally from its historically depressed levels over the long term, and that additional boost for the returns of overseas investors could draw more in. Still, we don’t expect a flood of investment into UK equities and the valuation gap relative to other developed markets looks likely to remain wide.
Chancellor Rishi Sunak outlined a swathe of additional stimulus in the March Budget (see our Budget update for more details). Due to the protracted timelines around the lifting of lockdown restrictions, the government has extended its support for workers and businesses. With tax and spending decisions together to tally almost £60 billion in stimulus over the 2021—22 fiscal year, plans were also laid by the Chancellor to start rebalancing the books. The largest tax rise announced at any budget since 1993 was thus pencilled in. Unfortunately, this is likely to coincide with the moment that the economy should be just about to get back on track.
environment for UK equities.
By international comparison, the UK government rolled out an extremely generous support programme in 2020 (figure 1). But it needed to — the UK had the second-worst economic fallout from COVID-19 among the 42 developed and emerging countries that we monitor. It has also suffered the second-worst health outcome to date, as measured by per capita deaths from the virus (after Belgium).
The UK has a larger consumer services sector than most other countries, so it’s been more sensitive to lockdown measures. Key industries in the UK were already ailing before the pandemic, while the private sector is also more indebted than that of other countries, increasing its fragility and limiting its propensity to bounce back.
Freeports or hidden costs?
In his Budget, Mr Sunak also announced plans for eight new freeports, which are typically located around shipping ports or airports. As the name suggests, any goods that arrive from abroad are free from tariffs that are usually paid to the government. These tariffs are only paid if the goods leave the freeport and are moved elsewhere in the UK. Otherwise, they’re sent overseas without the charges being paid.
Companies within the freeports benefit mainly from cheaper input costs, but they will also benefit from tax advantages, including a reduction in the tax they pay on existing property and new buildings. Employers will also pay reduced national insurance for new staff.
It’s hoped that the initiative will regenerate deprived areas by increasing manufacturing, creating jobs and encouraging investment. However, the evidence for their efficacy is decidedly mixed. Their success is dependent on access to infrastructure, skilled labour and capital within the zone, as well as how quickly an agglomeration of interconnected industries can become established. Some opponents argue that freeports don’t boost employment overall and that transferring economic activity from one area to another comes at the expense of the taxpayer. Others also fear that the freeports could facilitate an increase in tax evasion, corruption and crime. UK freeports are nothing new. The EU did not prohibit them and they have been used in Liverpool, the Port of Tilbury and Glasgow Prestwick Airport. There have been seven freeports in use between 1984 and 2012, when UK legislation permitting them was not renewed.
Figure 1: Direct spending related to the recovery (% of GDP)
Source: IMF, gov.uk, Deutsche Bank, Refinitiv, Rathbones.
Closing the gap
In the current environment, UK equity valuations look attractive compared with foreign equities across various measures. The gap between the prices of UK and overseas equities relative to their book value (assets minus liabilities) has widened to a degree not seen since the 1970s, when the UK had to ask the IMF for a bailout.
This gap was very small on the eve of the Brexit referendum, and widened as overseas investors shunned UK allocations to an extent never before recorded by surveys of institutional fund managers. But the widening gap was about far more than Brexit. The index’s bias towards two structurally impaired sectors — financials and energy — hasn’t helped, nor has its exposure to travel and leisure since the pandemic struck
With the most adverse Brexit scenario avoided, a strong global growth backdrop and a first-class vaccination programme, we expect some of that valuation gap to close and the UK to begin to outperform. However, we do not expect it to close entirely. The UK economy is fragile and more at risk of long-term scarring. Large exposures to financials and energy are likely at some point to begin to drag again.
has widened to a degree
The FTSE 100 no longer has the stable dividend that investors used to rely on (figure 2). Its exposure to industries such as oil and gas and mining may also be a concern for investors who are more focused on incorporating environmental, social and governance (ESG) issues into their processes. Some companies within these sectors could find themselves on the losing side of the low-carbon economy over the long term.
First small steps in a long journey
While a Brexit deal is good news, 80% of the estimated loss in trade from cutting ties with the EU stems from non-tariff barriers to trade, which the agreement does little to resolve. Moreover, the fog of uncertainty is yet to disperse over the UK’s outsized trade in services. Negotiations are continuing on several important ‘mini-deals’, covering issues such as cross-border financial services and the portability of accreditation to other professional services, which could all affect UK equities.
Meanwhile, the Budget brings stimulus today, but tightening further down the line. The risks of baking in a permanent economic loss could begin to weigh on the pound, but long-term currency valuation frameworks suggest the outlook is still one of appreciation. Shorter term, forecasting currency moves is just guesswork. As for UK-listed equities, we see better prospects for companies that earn their revenues overseas compared to those that are reliant on a recovering UK economy.
Figure 2: Expected year-on-year growth in dividends (%)