US Edition
The long-term economic impact of Brexit is unproven, but its effect on the UK stock market can be measured.
Between the financial crisis and the referendum, the London market moved in lockstep with Wall Street. In the years since, it has underperformed significantly. Obviously, coincidence is not causality, but consider the numbers.
Had you invested £100 in the S&P 500 on March 3 2009, and reinvested your dividends, you would have had an investment worth £350 on June 22 2016, the day before the referendum. The same amount invested in the FTSE 250 index, the most domestic of the UK’s stock market indices, would have risen to £355 on the same basis, an almost identical return.
In the nearly eight years since Brexit, by contrast, the S&P 500 has turned a £100 investment into £281 while the same amount in the FTSE 250 has grown instead to £140. The total return from the US stock market has, in other words, been more than four times greater since 2016 than it has been from an investment in our home market.
The consequence of that underperformance has been a wide valuation gap between the US and UK stock markets. The US trades on more than 20 times expected earnings; the UK is valued at just 11 times forecast profits. One market is frothy, perhaps in the early stages of a bubble. The other is undeniably cheap.
Two questions arise: is the discount justified by the fundamentals of each market? And, if it is not, what might trigger a narrowing of the gap?
The most common justification for the UK’s lowly rating is the sectoral composition of the market. We don’t benefit from the fast-growing, high-quality tech firms that have led the US market higher. Instead, we are weighted towards lower-growth, old-economy sectors like mining and energy. This is part of it, but it doesn’t tell the whole story.
Rathbones did some useful work on the valuation gap recently in a bid to compare the two markets on an apples-to-apples basis. It concluded that the gap narrows only slightly when adjusted for both sector differences and other factors like quality, growth potential and balance sheet strength.
Even after accounting for these, a significant discount remains. Firms in the same sector with identical growth and quality characteristics are cheaper if they are listed in the UK than in the US.
Rathbones also took on the Brexit question by running the same analysis using 2015 data. As the performance figures already mentioned suggest, they found no statistically significant discount relative to the US before the referendum.
Increased uncertainty about the UK’s economic outlook justifies the shortfall to an extent, but the analysis also found that the discount applies to multinationals as much as it does to companies earning all their revenue at home. It looks like there is another reason for the gap.
One that’s often cited is falling structural demand for UK shares thanks to legal and regulatory changes that have discouraged UK pension funds from holding UK equities. The shift has been dramatic. Defined benefit pension funds, which hold the majority of pension fund assets in the UK, now hold more than 70pc of their portfolios in bonds. Before 2000, 70pc was invested in shares, with a high weighting to UK stocks.
Again, that doesn’t tell the whole story. It does not explain the relatively strong performance between 2009 and 2016, despite the fact that the asset allocation shift was well underway throughout this period.
So, the more likely reason is that in the past eight years there has simply been a general pessimism about the UK economy and stock market, triggered by years of political uncertainty.
The good news is that the UK is starting to look reassuringly safe and boring on both the economic and political fronts. Whatever you think about the likely result of the election later this year, it is probably not going to change much from a policy perspective.
The debate has shifted to competence rather than the direction of travel. On most questions of substance, you can’t slide a cigarette paper between the two sides today. That’s reflected in the relative strength of the pound so far this year, with sterling being just about the only currency to have appreciated against the dollar.
There’s lots of hand-wringing about the health of the UK stock market. It is certainly shrinking as it fails to persuade companies that it is a good place to list their shares. At the same time, overseas investors are taking the opportunity to snap up businesses on the cheap and take them private.
There are lots of reasons that might be a problem for UK plc, but it is less of an issue for investors in the UK stock market. The significant premium at which takeovers are being struck, compared to pre-bid market prices, is a measure of the opportunity under our noses.
As I’ve written here already, I don’t think the launch of a British Isa is the solution to the problems facing the UK stock market. I don’t even think it will necessarily direct a huge amount of new capital towards UK-listed companies.
But at the margin I do think it has the potential to highlight the valuation advantage of British shares. It is not just about earnings multiples either. As and when interest rates start to fall later this year, the 4pc dividend yield available on both the FTSE 100 and FTSE 250 will also seem increasingly attractive to investors.
As markets around the world push further into uncharted territory, it is easy to dismiss the attractions of a market that has been off investors’ radars for the best part of a decade.
But as the risks of a correction rise elsewhere, and with the UK seemingly emerging from a very short and shallow recession, the case for our unpopular stock market is compelling.
Tom Stevenson is an investment director at Fidelity International. The views are his own
The case for Britain’s unpopular stock market has become impossible to ignore
After eight years of decline since Brexit, the UK is starting to look reassuringly safe again