LONDON (Reuters) – Britain’s economy faced the risk of recession late last year, while money flowed out of UK stocks and concerns over rising borrowing have resurfaced ahead of the March 6 budget, adding to uncertainty as a general election looms later this year.
However, investors are now debating whether UK markets are undervalued, with the possibility of a change in government boosting confidence in the economy. An expected victory for the opposition Labour Party, which is considered EU-friendly, could bolster the value of the pound. Additionally, the anticipation of forthcoming interest rate cuts should provide support to government bonds, or gilts.
Neil Birrell, the chief investment officer of Premier Miton, a London-based asset manager, believes that as the year progresses and the political landscape becomes clearer, along with the implementation of rate cuts, the true value of the UK market will become evident. Birrell stated, It could be one of the best performing markets of the year.
However, bond markets remain cautious for the time being. Ten-year gilt yields have risen by 52 basis points (bps) this year, while German and U.S. bond yields have increased by 30 bps each. The rising yields reflect the concerns surrounding Britain’s national debt, which is almost 100% of its gross domestic product. Finance Minister Jeremy Hunt has hinted at pre-election tax cuts in the upcoming budget, a move that has drawn a warning from the International Monetary Fund.
Cesar Perez Ruiz, the chief investment officer at Pictet Wealth Management, warns that any pre-election spending by the Conservative government or increased spending by Labour after an election victory could attract bond vigilantes. This is a reference to the market turmoil in 2022, when borrowing costs and mortgage rates skyrocketed due to a largely unfunded mini-budget and tax cuts by the Conservative government at the time, damaging Britain’s reputation for financial stability.
While some major investors are optimistic about gilts due to potential rate cuts as inflation eases, others, like Perez Ruiz, remain negative on both gilts and sterling. Markets have already priced in a 25 basis point rate cut in August.
On the other hand, Ed Hutchings, the head of rates at Aviva Investors, expects that gilts will outperform in comparison to other markets. Hutchings suggests that there may be hidden value in gilts that investors concerned about the political landscape have overlooked.
Sterling has seen a 2% gain against the euro so far this year, and speculators hold their most bullish positions in the pound of the last decade. Lefteris Farmakis, senior foreign exchange strategist at Barclays, believes that the disruptions caused by Brexit have led to the undervaluation of the pound. Farmakis suggests that if closer trading links with Europe are established, the long-term discount on sterling could be reversed. Labour leader Keir Starmer has pledged to strengthen ties with the European Union if his party secures a victory in the election.
UK stocks are currently trading at a 35% discount to global peers, reaching one of the widest valuation gaps in decades. Prior to 2016, UK equities traded at a premium. In 2023, over $36 billion flowed out of UK equity funds, nearly triple the amount lost in 2016 and the highest since at least 2008, according to Morningstar. Further indicating the lack of investor interest, European travel operator Tui has decided to leave the London stock market. However, merger activity driven by attractive valuations in the UK market is on the rise.
Pictet’s Perez Ruiz is actively searching the UK-focused FTSE 250 index for potential takeover targets, as he believes the UK equity market has attractive valuation prospects. Premier Miton’s Birrell also sees potential for renewed investor interest if political stability is achieved.
David Stevenson, a portfolio manager at Amati Global Investors, emphasizes that the UK market has experienced a highly unstable period since 2016 and is currently undervalued. Stevenson suggests that the market is waiting for a catalyst to regain momentum, predicting a significant rebound once sentiment improves.
In conclusion, while the UK economy faces various challenges, including the possibility of a recession, concerns over unsustainable borrowing, and a looming general election, investors remain divided on whether UK markets are undervalued. The outcome of the election and potential rate cuts will play a significant role in determining the market’s performance. While bond markets remain cautious, some investors see opportunities in gilts. Sterling has gained against the euro, reflecting anticipation of closer ties with Europe. UK stocks are currently trading at a discount, with the valuation gap reaching historic levels. However, political stability and a catalyst for renewed investor interest could contribute to a potential market rebound.
References: Sky News, The Guardian, Financial Times
