Are UK stocks about to shine?

Home to defensive and value stocks with a high sector allocation to mining, banking and consumer staples stocks, the UK stock market has been highly unpopular in the last few years due to the nation’s clouded economic outlook and political woes. As investors commended a higher risk premium to hold UK stocks it has left a valuation gap in comparison to international stocks. Thus, we are now noticing international investors taking interest in UK stocks again, as well some strategic investors attempting to seize mergers and acquisition opportunities (i.e. the offer on Anglo American).

A valuation discount gap set to close?

The FTSE 100 index, the benchmark for the largest 100 publicly traded companies in the UK trades near a historic low and lags behind peers. Its price-to-earnings multiple ratio is around 11.9x, which is still way below its historic average of around 13.5x. It makes the index appear cheap, in our view.   

FTSE 100 and FTSE 250 indices P/E ratio versus historic average

Source: BNP Paribas (Suisse) SA, FactSet data.

Some of the reasons for this discount versus its historic average, in our view, are to do with the domestic and global economic outlook which had been mixed but are now improving with a soft economic landing in sight as central banks are set to begin interest rate cuts and the economy is doing fine.

Lower rates should lift valuation multiples

Perhaps the most important element in the revival of the UK stock market is that central banks are about to lower interest rates. And typically for high-dividend defensive stocks this could be a positive catalyst to support their valuation to the upside. The mechanism is simple in theory, based on valuation methods such as the Dividend Discount Model, which values a stock by the sum of all its future dividends. And more importantly, those dividends are compared to the UK’s benchmark government bond yields, as it is the risk-free return that investors could get as an alternative.

The yield for the FTSE 100 (3.9%) and FTSE 250 (3.4%) are higher than those of US & Europe indices.

Source: BNP Paribas (Suisse) SA, FactSet data.

With interest rates headed down, it translates in lower bonds yields, and thus it should support high dividend stocks.

Consider government policies

Investors should keep on the look out for renewal of stock market volatility down the road, particularly for fears regarding fiscal decisions as infinite borrowing may prove unsustainable or simply more expensive.

Other key elements are government policies around energy and homebuilding reforms. Typically, these political decisions are a larger factor for small and mid-cap UK stocks, which tend to be more domestically oriented.

Conclusion

In conclusion, while we do not believe the UK stock market will necessarily outshine global peers overnight, the region is highly appealing for its high dividend yields and historical valuation discount. UK stocks may deserve a second look to be considered in a global portfolio and particularly so for the yield-seeking investor. 

This article is brought to you by the Advisory Solutions Team.