- U.K. GDP saw its sharpest contraction since 1979 in the first quarter, and the balance-of-trade deficit widened to £21.1 billion ($26.4 billion).
- U.K. stocks currently trade at a 19% discount to the MSCI World index, versus an average of 7% since 2002, UBS strategists pointed out in a research note Wednesday.
- S&P Global has cut its forecast for U.K. GDP in 2020 to an 8.1% contraction, warning of a "perfect storm" if Britain suffers a second wave of coronavirus infections and fails to negotiate a post-Brexit free trade agreement.
Although the U.K. faces a gloomy economic picture, UBS believes the country's assets are "heavily undervalued" and best placed to capitalize on the Covid-19 recovery.
U.K. GDP saw its sharpest contraction since 1979 in the first quarter, and the balance-of-trade deficit widened to £21.1 billion ($26.4 billion). However, strategists at the Swiss bank suggested that a promised £5 billion of government infrastructure spending and several key market dynamics place the U.K. in "pole position" to outperform.
"We see the UK as benefiting in an upside scenario for the global economic recovery, among other markets, including U.S. mid-caps, German industrials, and consumer brands," said Mark Haefele, the chief investment officer of UBS Global Wealth Management.
"In particular, we see sterling as the most notable beneficiary of the vulnerability of the U.S. dollar, which we expect to fall as safe-haven flows reverse and as political uncertainty mounts ahead of the November U.S. presidential election."
U.K. stocks currently trade at a 19% discount to the MSCI World index, versus an average of 7% since 2002, UBS strategists pointed out in a research note Wednesday, suggesting that this implies considerable upside potential over the next 12 months.
Net earnings-per-share (EPS) revisions, the balance of upward and downward revisions to analyst forecasts, have been improving on the back of rising oil prices, but stock performance has remained sluggish. EPS refers to a company's net profit divided by the number of common shares it has outstanding.
UBS believes that sterling is second only to the Japanese yen among G-10 currencies in terms of undervaluation relative to the dollar, with strategists estimating its purchasing power parity (PPP) with the greenback is 1.54, against a current exchange rate of 1.25. PPP uses the prices of particular goods to compare the absolute purchasing power of currencies in various countries.
The note also highlighted that some value stocks (those which trade at a low price relative to their fundamentals) and cyclical sectors (those which generally track economic performance) which have upside potential in the Covid-19 economic recovery align well with the U.K. equity market. In particular, the FTSE 100 has a 40% cumulative exposure to value sectors such as banks, basic materials and energy.
"Notably, the U.K. would benefit from a recovery in the Brent crude oil price, which we expect to rise to USD 55 a barrel by the end of the second quarter of next year," UBS strategists said. Energy stocks account for 12% of the FTSE 100 index, compared to just 4% for the MSCI World index.
S&P Global on Wednesday cut its forecast for U.K. GDP in 2020 to an 8.1% contraction, warning of a "perfect storm" if Britain experiences a second wave of coronavirus infections and fails to negotiate a post-Brexit free trade agreement with the European Union.
The U.K. has passed the June 30 deadline to request an extension to the current transition period beyond the end of 2020, meaning its future trading relationship with the bloc will have to be determined over the next six months.
Berenberg Chief Economist Holger Schmeiding noted Thursday that despite an extension being off the table, the tone from British and European leaders has softened, with both sides floating possible compromises over governance, level playing field provisions and politically sensitive fisheries. But despite signs of progress, Berenberg does not expect a deal before year-end.
"Instead, we expect the two sides to agree on some modest stopgap measures in order to prevent a disorderly hard exit," Schmeiding said.
"Instead of one big cliff edge, where the U.K.-EU economic relationship suddenly shifts from open single market rules to the much more restrictive World Trade Organisation rules for trade, we expect the two sides to see to it that the switch occurs in a series of smaller steps."
S&P Global now assumes that a "core" trade agreement will be reached, rather than the comprehensive accord once hoped for by the markets, and suggested that the switch to this regime will dampen the 2021 rebound and drag on growth in the coming years. The ratings agency now expects that the U.K. economy will be around 3% smaller in 2022 than initially projected before the pandemic.
Despite the potential headwinds, however, Haefele's UBS team believes the monetary and political risks are "overdone" and overstating the concerns that no agreement is reached, owing to a clear incentive for both sides to avoid such an outcome.
"We also believe markets have been exaggerating the risk of the Bank of England reducing rates into negative territory, a potential drag on the pound," the UBS note added.
The Bank of England revealed last month that it had been assessing the impact of negative rates, but Governor Andrew Bailey confirmed that this was not an immediate consideration, and the Bank's Monetary Policy Committee (MPC) did not discuss it at June's policy meeting.
"As these risks subside, we expect the pound to regain ground and investment into the U.K. to pick up," Haefele concluded.