After years of lagging behind peers, UK stocks are emerging from the Brexit shadow just as cheap stocks are getting a boost from bets of a global recovery from the pandemic.
The country has been the worst performer among major equity markets since the 2016 Brexit referendum, both in local currency and dollar terms. For investors who have steered clear of UK shares during the period, their cheapness may hold allure as value stocks are forecast to shine in the coming year.
On Christmas Eve, the UK clinched a historic trade deal with the European Union as negotiators finalized the accord, which will complete Britain's separation from the bloc. The news comes as the UK has locked down 16 million Britons amid a spike in Covid-19 cases and an appearance of a new strain of the virus, with more restrictions on the way from Dec. 26.
"The last-minute deal between the EU and the UK is a good case to be made for the UK market in the context of value hunting," said Oddo BHF strategist Sylvain Goyon. "The 'end' of the Brexit saga could be an interesting trigger to rediscover the FTSE 100." The benchmark is geared toward industries that are sensitive to the expected synchronized economic recovery in 2021, Goyon added, with materials, energy and financials accounting for about 40% of the index.
The agreement will allow for tariff and quota-free trade in goods after Dec. 31, but that won't apply to the services industry -- about 80% of the UK economy -- or the financial services sector. Firms exporting goods will also face a race to prepare for the return of customs and border checks at the year-end amid warnings of disruption at Britain's ports.
The exporter-heavy FTSE 100 has risen 2.5% since the 2016 vote, underperforming the 14% gain for a broad regional benchmark, the Stoxx Europe 600 Index, despite a boost from the falling pound. In dollar terms, the UK index has fallen 6.7%.
In another sign of the UK's unpopularity, investors paid little heed to the market-leading earnings growth of FTSE 100 companies, put off by the lack of visibility on Brexit. That has left British stocks trading near record-low valuations relative to global stocks, based on estimated earnings.
"We remain positive on UK equity," Goldman Sachs Group Inc. strategist Sharon Bell wrote on Friday. "The market already looks cheap versus other assets and versus other major equity indices."
Most UK sectors trade at a "substantial discount" to both European and U.S. peers, Goldman said. The firm is overweight the FTSE 100 relative to the Stoxx Europe 600 Index, citing compelling valuations and a tilt toward value shares and sees the megacap gauge as far less sensitive to Brexit outcomes than FTSE 250 or domestic stocks.
Within the UK, stocks that have borne the brunt of dragging negotiations are also likely to benefit the most from the resolution, including banks and homebuilders. And while a strong pound typically weighs on the FTSE 100, the two have enjoyed a positive correlation since October.
Financial and energy shares, which have a heavy weighting in the megacap gauge, may also get a further boost from the value trade. Additionally, Artemis Income Fund manager Nick Shenton predicts a recovery in dividends in 2021 as companies become more confident to move away from this year's "extreme prudence."
At least some Brexit boost is already in stock prices, as optimism over an accord grew in recent weeks. That, along with bets of a vaccine-fueled economic recovery, has pushed the FTSE 100 up 17% since the end of October and the FTSE 250 up 19%.
Fund managers turned less bearish on UK equities in the run-up to the Brexit deadline, according to Bank of America Corp. In a survey by the bank, a net 18% of respondents were underweight the country's equities in December versus 34% the previous month. Still, the country held on to the dubious distinction of being the least-preferred among major stock markets in December, the survey showed.
While most strategists agree that a Brexit deal bodes well for the UK market, and that it is well-positioned to benefit from the vaccine-led economic recovery, the degree of bullishness varies.
UK assets are underowned, undervalued and offer investors greener growth, Societe Generale SA strategists led by Alain Bokobza wrote on Dec. 16, while Liberum Capital strategist Joachim Klement said last month that a multiyear bull market has started for British stocks, predicting they will re-rate by as much as 50% over the next two years.
On the other hand, JPMorgan Chase & Co. strategist Mislav Matejka doesn't expect UK equities to outperform euro-area or global peers, saying the FTSE 100's defensive stocks may hold it back as the economy reflates and that the pound's strength could be a drag at least in the short term.
While most investors preferred any trade deal to the UK leaving the EU without one, it remains to be seen whether the agreement that's been struck will be enough to fully restore confidence in UK equities. Beyond the short-term bounce, Brexit may take the sheen off the market in the long run, according to Seema Shah, chief strategist at Principal Global Investors, as an exclusion from the single market will likely see jobs and capital flows trickle away.
"One of the big, unanswered questions remains whether those international investors who aggressively sold their UK equity exposure following the 2016 referendum will be tempted back to the market, given still-attractive valuations relative to developed-market peers," said Richard Buxton, head of strategy, UK Alpha at Jupiter Asset Management. The process may be slow, he said, with many likely to "wait and see" how the UK fares outside of the EU.
Disclaimer: This article first appeared on bloomberg.com and is published by special syndication arrangement.