UK stocks : opportunities for long-term investors

Ritu Vohora, investment director in the M&G equities team

Theresa May’s decision to step down has further increased uncertainty over the process of the UK exiting the EU which is set for 31 October. There is likely to be significant uncertainty and volatility ahead making it difficult to forecast and come up with any rational financial analysis. It’s more important to focus on the fundamentals and what is priced in.

Sterling weakness may benefit the UK large cap equity market

For investors, sterling continues to be the main channel to express their views around the Brexit outcome. The pound has lost most of its value against the euro and dollar over the past few weeks and remains under pressure. Sterling weakness may benefit the UK large cap equity market as the majority of the FTSE 100 revenues come from overseas. However, the rising risk premia related to policy uncertainty or a significantly stronger pound could also cause UK stocks to underperform their peers. It is hard to predict the outcome of Brexit and short term swings can quickly reverse.

Two scenarios for equity markets

Equity markets would react most positively to a ‘deal’ or if the UK decides to remain in the EU and worst to a ‘no deal’ so it is important to look at the positive and negative scenarios from an equities perspective.

Positive scenario – Some form of a deal is made or the UK remains in the EU. This would provide a relief rally as uncertainty is lifted. The pound and UK growth would rise which would help equities, especially FTSE 250 vs FTSE 100 (which would be adversely impacted by sterling’s strength and exports relatively more expensive). Domestic stocks especially in the FTSE 250 would the biggest beneficiaries, particularly domestic banks and real estate along with housebuilders and retailers. Negative scenario – ‘No deal’. This would likely cause downward pressure on valuations but a collapse in sterling could help propel the FTSE 100 higher, given its relatively low domestic exposure where more than 75% of revenues are overseas vs around 50% in the FTSE 250 which has a natural hedge.

Pharmaceuticals, technology and commodity sectors are likely to be relative outperformers due to their low domestic revenues whilst the FTSE 250 would de-rate further, especially domestic sectors such as banks. UK equities still offer geographic and industry diversification, with a near 5% dividend yield which seems attractive compared to competing yields on cash and government bonds. Equity valuations in the UK market also look attractive and despite Brexit risks dominating the market, a lot of the concerns have already been priced in. Brexit, for all its unintended consequences, has opened up some opportunities for long-term investors.