You can’t really blame international investors for steering clear of UK equities over the past few years. Even for someone based in the UK and with a keen interest in politics, it has been nigh-on impossible to stay on top of the many political twists and turns. The sheer number of market-relevant open questions was mind boggling. Who controls the Brexit process? Who will be the Conservative leader? Will there be an early election? Who will be the next prime minister? Could there be a far-left prime minister? When will Brexit happen? What form will Brexit take?
With UK equities only accounting for a small part of global equity benchmarks, it would have taken a disproportionate amount of time and effort to stay on top of all these developments. It was easier not to be involved and focus scarce research time on other topics.
This trend left a mark in a lot of places. Fund-flow data showed unprecedented outflows from UK equity funds. Surveys repeatedly flagged the UK as far and away the least popular region for equity investors. One of my personal favourites was an October survey showing the UK as the region investors thought was least likely to outperform over the next decade. Capitulation.
In equity terms, this political risk premium was reflected in a broad de-rating against other regions. UK stocks traditionally trade on a higher dividend yield, but the yield gap between the FTSE 100 and MSCI World indices roughly doubled over the past few years. It’s a similar picture on earnings multiples. Most of the UK’s underperformance in the run up to the EU referendum had been driven by a lack of earnings growth. But since then, de-rating has contributed a large part of the underperformance.
We don’t expect the political risk premium to disappear overnight: while there is less uncertainty than last year, there are still some unanswered questions and global portfolios are not all adjusted instantly. As of mid-January, about a quarter of the outflows has reversed as well as a smaller proportion of the relative de-rating.
We initiated a long position in UK equities against other developed markets ahead of the December election. With valuations forming a significant part of the investment case, we expect to hold this position for longer than just a tactical bounce.