Deep Dive: There are many factors to consider in UK equities

We have been arguing for some time that inflationary pressures were unlikely to be short-lived, partly due to the difficulty the UK is having in solving its supply-chain problems. Indeed, the focus on the green revolution has left many sectors – particularly energy – underinvested for decades. 

The extraordinary fiscal and monetary stimulus that followed last year’s Covid crisis, combined with strong growth momentum, has resulted in significant inflationary pressures. Both our proprietary inflation ‘nowcasters’ and ‘newscasters’ pointed towards an elevated inflation surprise risk towards the end of last year and remain firm today. 

In theory, the high inflationary environment should have benefited the UK equity market, which has historically been particularly cyclical. If we compare the FTSE 100 index with the S&P 500 index, the former has approximately 17% exposure to both consumer staples and financials and over 10% exposure to energy stocks. 

Its US counterpart on the other hand has a much larger tilt towards technology stocks (27%) and just 3% in energy stocks. 

One might therefore expect UK equities to outperform, yet this has not been the case. When looking at the performance of the UK market relative to the US, the FTSE 100 is up 12% year to date versus 22.5% for the S&P 500 (as of 29 October 2021). 

Despite a favourable environment for UK equities, we believe this underperformance can be partly attributed to the extraordinary fiscal and monetary stimulus that took place in the US during the pandemic. Ongoing post-Brexit uncertainty also means that many investors have not yet returned to the UK market, but instead have found the risk/reward is more attractive in other regions at this stage. Finally, the Bank of England remains one of the most hawkish central banks within the G10 space and is expected to raise rates before the end of year to combat inflationary pressures. This should act as a further headwind for some UK equities.

UK vs US stockmarket since 2015

Following Brexit, and the rising uncertainty that followed, many investors chose to move their exposure away from the UK and allocate their cash elsewhere.

Although a large part of these uncertainties disappeared following Boris Johnson’s Brexit deal, investors still face the issue of a complex divorce process, which is still making headlines today. Discussion, notably around the Northern Ireland Protocol, will likely continue to fuel uncertainty as the situation is not only complex but also tense. Rows with former partners, such as with France on fishing licences, does not help the situation.

The reflation theme should continue to drive asset and sector rotation and although these macroeconomic dynamics should continue to support UK equities going forward, we have only a small exposure to UK assets at this time and maintain a neutral stance. 

The post-Brexit deal negotiations and recent energy crisis – as well as a resurgence in Covid-19 cases due to a more laid back approach than many European counterparts – means that the risk of further lockdowns is also higher. 

Although UK equities can be seen as one way of playing the ‘reflation trade’ by many investors, we prefer to express that view by being long inflation breakevens and cyclical commodities, which we consider to be a cleaner expression, therefore removing the UK political risk premia such as Brexit and currency fluctuations. 

Jeremy Gatto, Multi Asset Investment Manager at Unigestion

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