The UK stock market has underperformed since the current global stock market rally began at the end ...
The UK stock market has underperformed since the current global stock market rally began at the end of the first quarter last year. Further underperformance is anticipated over the coming six months, as investors brace themselves for interest rate increases.
Over the eleven months since the UK market"s nadir on 12 March 2003, the 34% return from the MSCI UK Index, although impressive, is still behind the 43% return produced by the MSCI World Index, while it looks positively pedestrian compared to the massive 81% return from the MSCI Germany Index over the same period (returns in local currencies, source Datastream, 12/3/03 - 12/2/04).
Given the relative strength of the underlying economy, with GDP growth last year of +2.1% compared to -0.1% in Germany and +0.5% for the Euro zone, this underperformance may at first glance be surprising.
After a closer look, however, it is possible to see that there are two good reasons why the UK market has been lagging in the performance stakes. Partly, it is because the UK is less exposed to global economic growth than many of its more cyclical counterparts, being dominated as it is by domestic banking stocks, drug makers and oil producers.
This is particularly apparent when compared to highly cyclical markets like Germany. Bearing in mind that the UK never suffered the same heavy losses as Germany during the bear market, largely thanks to its more defensive makeup, but also because UK economic growth never collapsed to the same extent as in Europe"s largest economy, it is perhaps unsurprising that when markets and growth bounced back, Germany experienced the biggest rebound.
The second reason for the UK"s recent underperformance, which has been an influential factor in recent weeks, is its sensitivity to interest rate hikes. The Bank of England has been tightening monetary policy to rein in surging consumer debt and house price inflation. There have been two recent interest rate hikes (in November and February) that have taken base rates from a 45-year low of 3.5% up to the current 4% level.
The UK central bank is also concerned that a diminishing output gap is storing up future inflationary pressures, making further rate increases inevitable. Indeed, in its latest Quarterly Inflation Report (which contained the first inflation forecast based on the newly adopted HICP method that excludes the cost of housing in owner-occupied properties), the Bank of England said that it expects inflation to rise sharply towards its 2% target over the next two years.
Although these rate increase fears have understandably managed tp cause some nervousness among investors, which in turn has hindered stock market progress, the market does not expect much more than another 50 basis points of tightening this year, deeming that the Bank of England will be concerned not to totally undermine consumer spending and kill off economic growth. The market expects further rate rises to be restrained, as the central bank attempts to produce a gentle rebalancing of the UK economy towards industrial-led growth.
However, recent data suggests that this rebalancing may now already be taking place. The January survey from the Confederation of British Industry, for example, pointed to the fastest pickup in new orders from manufacturers since the mid 1990s, confirming that UK manufacturing has emerged from the doldrums. Meanwhile, the Bank of England"s latest economic forecast is very strong, suggesting that UK GDP growth will remain well above trend levels at more than 3% this year.
Clearly, with UK GDP growth accelerating as industrial growth starts to come through, and global demand still rising, the risks are skewed towards larger-than-expected rate increases. Therefore, although the market is still only discounting another 50 basis point hike by the end of the year, the risk is that it may be nearer 75-100 basis points.
As a result, our UK portfolios, through our process of bottom-up stock picking that concentrates on the best growth and value stocks, are positioned to benefit from expectations for higher interest rates. There has been a move away from consumer-sensitive stocks, which could be hit by higher rates and a slowdown in consumer spending, into sectors that are likely to benefit from the strong global and domestic economic backdrop and expectations for rising corporate spending.
Although stock market valuations are cheap relative to many other major markets, earnings growth is likely to be relatively modest (reflecting the large share of defensive stocks). Therefore, we currently underweight the UK in our global balanced accounts, preferring markets with a greater leverage on global growth, such as those in continental Europe and the Pacific. If global growth slows unexpectedly then the defensiveness of the UK stock market will be an advantage, but that is currently looking unlikely.
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