UK valuations are at 30-year lows compared with international equities as a whole, touching levels last seen in the early-1990s recession when judged by a range of measures.1 Similarly, sterling is now back at a 34-year low against the dollar.
That the UK market is so unloved typifies the high levels of consensus thinking in financial markets generally, with free money and negative yields driving excessive risk taking and misallocation of capital. The market's reactions are either black or white, there are no shades of grey. Sentiment swings from one extreme to the other, whether in terms of global equities as a whole, UK equities versus other markets, or different styles of stocks such as growth or value.
In 2019, the consensus regarding global equities generally changed radically. At the end of 2018 doom and gloom dominated due to concern that US monetary conditions were too tight; but after the dovish pivot from the Federal Reserve in January 2019 that turned to euphoria as the market anticipated that the Fed would lower rates. Extreme positioning meant that the late-2018 sell-off was therefore more violent than it should have been, exacerbated by passive funds scrambling out of the same positions - by spring 2019 they had scrambled back in.
Market metrics are at multi-decade extremes
Within the UK market there is huge bifurcation in company valuations - while a fifth of the FTSE All Share index companies trade at high forward price/earnings (P/E) valuations exceeding 20 times, more than a third of them are at bargain basement levels of below 10. In this environment you have to beware over-optimistic valuations and keep a sharp eye on your highly valued stocks to make sure their cashflows are as strong as expected. It's important not to be too exposed to one theme such as quality growth in case the long-awaited rotation from growth to value happens.
But it's too simplistic to say all stocks trading on P/E ratios under 10 are attractive. On a case-by-case basis there are some interesting opportunities. So it pays to go hunting for these out of favour stocks.
There is also a third part of the market trading between the two valuation extremes. Some of these stocks are international businesses that are not particularly beholden to the UK economy. But their valuations have been de-rated simply because they are listed in London and the weight of money has flowed from the UK. As a result they are trading at lower valuations than their peers listed in Europe or the US.
Selling England by the pound!
For evidence of the UK's low valuations look no further than mergers and acquisitions, which are at a 10-year high despite the political uncertainty.2 Unlike asset allocators, corporate bidders are willing to ignore the noise and focus on valuations. So while market practitioners are ignoring UK equities, private equity and US corporates are taking full advantage of the valuation arbitrage. Typically, M&A is more prevalent later in the cycle when shares have recovered from early-cycle lows, whereas a lot of the UK market is currently languishing at cycle-low valuations. As a result, we saw many examples of UK businesses subject to takeover bids in 2019 including Cobham, Greene King and Inmarsat. Which company will be next?
Waiting for a reappraisal
Trends can go on longer than you expect but waiting for greater clarity is a dangerous game - when it finally arrives, markets are likely to move very quickly. It is not just landlocked domestic companies that have been affected by negative sentiment towards the UK. We think that there are opportunities across the market, in domestically and internationally focused companies. All will benefit from a reappraisal of the UK market when that occurs.
2020's biggest event for UK equities happened before the year began with the general election in December. The strong Conservative victory has removed political uncertainty - and one thing markets dislike is uncertainty. This means that whatever type of Brexit we eventually see, we know that the Conservatives now have a mandate to deliver our exit from the European Union. Also, the greater clarity we now have should not only spur an immediate stock market rally, but also encourage a longer lasting reappraisal of UK-listed companies. Global asset allocators who had fallen out of love with the UK will likely shift money back to the region
But the market's extremes and mis-allocation of capital make it a good time to be an active manager. The wide range of valuations in equities is producing some attractive opportunities. Indeed, we are more animated about the prospects for some of our stocks now than we were five years ago.
Charts to keep an eye on in 2020
UK VS. WORLD ON PE, DIVIDEND YIELD & PBV
Source: Bloomberg, as at 31 October 2019 and Morgan Stanley, as at 31 October 2019.
FTSE ALL SHARE COMPANIES SPLIT BY PRICE-TO-EARNINGS RATIO
Source: Columbia Threadneedle Investments, Bloomberg, as at 11 November 2019.
Read more of our investment teams' outlooks at columbiathreadneedle.co.uk/2020
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