We don’t think that the recent underperformance of UK equities will continue. But we no longer expect them to make up the ground that they have lost to their peers since the virus hit.
- We don’t think that the recent underperformance of UK equities will continue. But we no longer expect them to make up the ground that they have lost to their peers since the virus hit.
- Since the plunge in equity prices in March, UK equities have underperformed those in the US and elsewhere. While the S&P 500 is down by 1% compared to the level on 19th February, just before the virus caused global equity prices to plunge, the FTSE 100 is down by 19%. That’s a gap of 18ppts. (See the solid black and blue lines on Chart 1.)
- Two factors explain most of the divergence. First, companies in sectors that have underperformed because of the virus, such as energy, financials, utilities and industrials, have a larger weight in the UK index of 46% compared to 26% in the US. Accounting for this and any currency impact by looking at the MSCI UK index in dollar terms and adjusting the sector weights to match the composition of the US stock market, UK equities are down by a much smaller 11% since February. That narrows the unexplained gap between the US and the UK to 10ppts. (See the dotted blue line in Chart 1.)
- The second reason for the divergence is the idiosyncratic boost to the US stock market from the FAANGs. Without the tech giants, the US index would still be 5% below its February level. (See the dotted black line on Chart 1.) This reduces the underperformance to 6ppts. The remaining gap may be due to the large hit from the coronavirus to the UK economy and stalling Brexit negotiations. Indeed, UK small caps, which generate most of their revenue domestically, have underperformed those in the US and the euro-zone.
- We think the drag on UK equities from these factors will soon fade. If the virus is contained and economies continue to recover, the FTSE 100 should benefit as the sectors that have underperformed this year start to outperform. (See here.) And we doubt that big tech will continue to outperform. (See here.) Admittedly, as 77% of the FTSE 100’s earnings are generated overseas, an appreciation in the pound from $1.29 to $1.35 if there is a Brexit deal (as we assume) would weigh on earnings in sterling terms. But we suspect that the good news on Brexit would offset this. So we expect the FTSE 100 to climb from here.
- However, whereas we previously expected UK equities to catch up with their global peers, we no longer expect them to outperform. Our view that interest rates will be at rock-bottom for the foreseeable future will mean that banks, which carry a large weight in the UK index, continue to struggle. Meanwhile, our forecast that the wider economic recovery will slow is broadly in line with the consensus, so the economy would need to be much stronger than we expect to supply a boost to equities.
- The upshot is that we are revising down our FTSE 100 forecast from 7,100 to 6,200 at end-20 and from 7,860 to 6,600 at end-21 before it regains its pre-virus level of about 7,500 at end-22. (See Chart 2.)
- Of course, the UK and EU may not agree a Brexit deal, but the FTSE 100 would not necessarily fall. While domestic earnings would be downgraded and small caps would suffer, the boost to foreign earnings in sterling terms from a fall in the pound from $1.29 now to $1.15 would prevent a big fall in the FTSE 100 as it did in the aftermath of the EU referendum in 2016. So for the FTSE 100 a no deal may result in much the same outcome as a Brexit deal, but for different reasons.
Chart 1: MSCI Indices (19th Feb. 2020 = 100)
Chart 2: Large-Cap Equity Indices
Sources: Refinitiv, Bloomberg, Capital Economics
Sources: Refintiv, Capital Economics
Andrew Wishart, UK Economist, +44 (0)7427 682 411, email@example.com