On paper, the UK is in dire straits.
Among the world’s major economies, it has the fastest inflation, at over 8%. It has some of the highest interest rates, with the Bank of England considering a second in a row half point increase in August. And although it is not in recession like its neighbor Germany, the outlook is for lukewarm growth for the next few years.
That pessimism has been reflected in the performance of the FTSE 100 index this year. While the S&P 500 is up 17%, Japan’s Nikkei is up 24% and Germany’s DAX is up 16%. The FTSE 100, by contrast, has been flat.
The good news is that this is an opportunity for smart investors, for two reasons. One, FTSE 100 companies make 80% of their profits outside of the UK; They do not depend on the national economy. And two, UK company valuations are trading at around a 20% discount to their global peers, according to Charles Luke, investment manager at
That gives them room to catch up.
The UK market “is cheap in absolute terms, relative to history and also relative to global equities,” Luke said in a June 28 report. “Investors are getting global income at a knockdown price.”
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The composition of the UK sector could make it a good play for the second half of the year, said Hugh Gimber, global market strategist at
Asset Management in London.
While US markets have been driven higher by technology stocks, the FTSE has more financial companies, which will benefit from higher interest rates.
As long as inflation stays stubbornly tall in the UK it should start to decline rapidly now, just as it already has in the US and other countries, largely as energy prices remain lower than a year ago. He headline rate fell higher than expected in June to a 15-month low of 7.9%.
That could bode well for consumer staples stocks like the beverage maker.
(ticker: DGE) or manufacturer of goods
(ULVR).
Diageo
,
With a market capitalization of around $100 billion, it’s down 6% this year, and most analysts give it a Buy rating with an average 11% upside price target. Its price-earnings ratio is in line with its peers. In its last-half earnings in January, it reported slowing growth in North America, where it sells Don Julio and Casamigos tequila.
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it is down 2.6% since January 1 and has an implied 8.2% upside in the median price target.
Falling inflation could also boost travel-related stocks, such as the owner of British Airways
Consolidated international airlines
(IAG), which has already gained 27% this year. That’s still less than share price gains of more than 45% in US rivals.
(AAL) and
(UAL).
energy giants
(SHELL) and
(BP) have performed very similarly to their peers, but their shares are still trading at a significant discount. BP is trading at 6.4 times future earnings,
is at 7.5 times.
exxons
,
the largest US oil producer, is trading at 11 times earnings by comparison.
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BP shares have fallen more than 15% since February. Like its peers, it has been hit by falling oil prices this year, but in its latest earnings in May it beat analysts’ estimates for profitability. With a market capitalization of about $105 billion, the company vowed to be disciplined with investments, reduce debt and increase distributions to shareholders.
The UK got into its current situation through bad luck and some bad decisions. A tight labor market is keeping pressure on inflation, just as in the US, and the UK was also heavily exposed to the rise in natural gas prices after Russia invaded the Ukraine, like the rest of Europe. It was a double whammy that caught the Bank of England by surprise, even though the UK central bank started raising interest rates months before the Federal Reserve.
On top of that, the UK’s messy breakaway from the European Union is dragging down economic growth and clogging supply chains. And an ephemeral attempt to open the supply side of the economy with big tax cuts last fall under the two-month term of Prime Minister Liz Truss spooked the bond market, driving up yields. Trust in the government may have recovered somewhat since then, but ongoing battles over pay for nurses, teachers and train drivers still weigh on trust.
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Although the growth outlook is bleak, the outlook for stocks is brighter.
“The UK economic outlook is more challenging than in other parts of the world,” said JP Morgan’s Gimber. “But the stock market could really benefit.”
Write to Brian Swint at brian.swint@barrons.com