EXPERT INSIGHT FROM BLACKROCK FUNDAMENTAL EQUITIES

UK stocks: Inflation, recession – and opportunity

01-Nov-2022
  • Adam Avigdori
  • Oliver Dixon

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

We expect UK assets to remain in the headlines over coming months. This presents opportunities to find quality companies whose share prices have been dragged down with the overall market. Our views on UK equities:

  • Increased buybacks and attractive dividends boost UK stocks on a total-return basis
  • A weak sterling helps cushion companies with dollar-based earnings from the impact of recession
  • We see selective opportunities within healthcare, homebuilders and even retail names

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New fiscal measures from the UK government were expected to stoke inflation just as the Bank of England is taking strong steps to tame it, and an abrupt turn on these policies could lead to growth-sapping spending cuts. The expected economic hardship, including the possibility of a deep recession, is leading to increased volatility in UK financial markets.

UK assets have suffered 1. And we believe earnings for many UK companies may fall next year – and we expect a wider gap between the winners and losers. UK equities have been getting steadily cheaper versus global stocks since 2016, as the chart below shows. Yet the recent plunge in prices makes them cheaper now versus global stocks than any time since the Global Financial Crisis (GFC) of 2008. This provides an opportunity for stock pickers, in our view.

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UK vs. World equity valuations. 2006-2022

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. The return of investments may increase or decrease as a result of currency fluctuations. Sources: J.P. Morgan, October 2022. The chart shows the price-to-earnings ratio of UK stocks (MSCI UK) relative to world stocks (MSCI World). The indices have been adjusted to make them “sector neutral,” to balance out the weight of historically cheaper or more expensive sectors. P/E ratio stands for Price to Earnings ratio, which is a valuation metric showing a company’s price in relation to its earnings.

UK stocks look cheap…but don’t take our word for it

It is true that UK stocks have been cheap versus their global peers for the past few years. So why do valuations support the case for UK equities now? Not only has the UK discount widened to a level not seen since 2008, but companies are buying back record amounts of their own shares, as the chart below shows. This tells us that management teams have confidence in their own businesses and think their shares have become undervalued.

FTSE 100 share buybacks, 2002-2022

Source: BlackRock and Bloomberg, October 2022. The chart shows the value of their own shares FTSE 100 companies said they will buy, 2002 to October 2022.

The £51 billion in share buybacks recorded so far in 2022 equates to a nearly 3% buyback yield on the FTSE 100, according to our calculations. When this is added to a dividend yield of 4.5% – the highest among developed markets, as the chart below shows – the combined income totals more than 7%. This compares to the current yield on UK 10-year gilts of around 4%.

Global dividend yields

Source: J.P. Morgan, October 5, 2022. The chart shows the dividend forecasts for the next 12 months for the FTSE 100 index (UK), MSCI Europe ex UK Index, the Topix (Japan), MSCI AC World and S&P 500 (U.S.). There is no guarantee any forecasts made will come to pass.

Defensive dollar earners

Sterling has also been under pressure amid the macroeconomic uncertainty. Yet this currency weakness provides a boost to many of the UK’s larger companies, as 70% of revenues in the large-cap FTSE 100 are earned abroad, according to Bloomberg in October

Yet we see earnings downgrades coming as a the UK economy faces potential recession. We believe it’s important to be selective among the large, multinational dollar earners. We look for those defensive companies that have strong balance sheets and have historically shown reliable, recurring revenues throughout economic downturns. Some of these companies can be found in the healthcare sector, primarily pharmaceuticals. We also find companies with these characteristics among information and analytics providers.

Looking deep among domestics

UK portfolios have mostly tilted towards the “defensive,” multinational companies described above. But the valuation discount is so extreme that we are beginning to find opportunities among domestically focused stocks – especially those we believe are in a strong position to weather a potential recession.
Some homebuilders and hotel companies are trading at levels not seen since the GFC. We believe companies, like these, that own real assets such as land and property are attractive during a period of higher inflation. And these real assets – priced in sterling – are likely to look appealing to international buyers.

These are challenging times for investors in UK assets. But we believe an active approach can identify long-term opportunities amid the volatility.

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1 Source; FTSE All Share Index YTD to 30/9/22 -7.9%, FTSE 250 Index YTD to 30/9/22 -25.3%