Why austerity could be good for UK stocks

Plans to tackle the deficit may be a buy signal for UK shares. Many people have given up on the UK stock market in the past year or two. That's hardly surprising given the state of UK plc.

There's no doubt we're in a hole. The new Chief Secretary to the Treasury, the Liberal Democrat David Laws, revealed that his predecessor Liam Byrne had left him a one-sentence note of introduction to the job. Laws no doubt expected a few comradely tips on dealing with Whitehall - or at least where to get a decent coffee first thing in the morning. But it simply read: "I'm afraid to say there's no money left".

At least it's honest!

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With the emergency budget now dated for 22 June, Britain is bracing itself for a wave of public spending cuts and tax rises to turn its tanking balance sheet around. Some think the pain could be worse than we've experienced in living memory. So man the lifeboats? Invest in emerging markets? Not so fast.

Squids in

We've mentioned before that the UK stock market is much more reliant on overseas earnings than it is on the UK economy. Estimates vary - and fluctuate with exchange rates - but at least 75% of the stock market's earnings are generated overseas. Buy the UK market and you get global exposure.

Now a bright chap at Goldman Sachs has worked out that investors in UK companies shouldn't just be reassured by this overseas exposure while the government is tackling the deficit we should be drooling!

To reach this contrarian conclusion, Goldman's Peter Oppenheimer has delved into his database to study three other periods when the UK experienced massive fiscal tightening. He then looked at the UK stock market's performance, compared to the rest of the world.

UK shares and previous fiscal adjustments

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Source: Goldman Sachs

What this table shows us is that when the UK government has cut back, the UK market has historically done better compared to the rest of the world's stock markets. It's particularly clearly shown by the comparative P/E re-rating in the last two rows.

With the UK market the relatively cheapest it's been at the start of fiscal tightening this time (at a ratio of 0.69), the P/E re-rating could be particularly pronounced.

On the other hand, our budget deficit compared to GDP is the worst it's been, too!

Two reasons to buy the cutback theory

What's going on here? Well, two obvious explanations spring to mind.

The first concerns the exchange rate. I've already mentioned how the bulk of the UK stock markets' earnings are derived overseas. If the pound weakens versus other currencies in the run-up to the government's austerity measures, then subsequent overseas earnings of UK companies will rise in sterling terms.

That seems to be what's happening this time. The pound has slumped far below the heady levels of £1:$2 of just a couple of years ago. It recently approached £1:$1.44.

Peter Oppenheimer particularly likes this theory; he points out that the pound also weakened before fiscal tightening in the other periods he studied.

The other reason that occurs to me is fear and pessimism. As the country's finances deteriorate, investors perhaps become over-scared of investing in UK equities, just as many people prefer to buy growth stocks rather than value shares, despite the latter's superior record.

When the government begins to get the public finances under control, however, the mood surely becomes more optimistic. More gung-ho investors may then be willing to put a higher valuation on UK shares.

There's a caveat

I've long been persuaded that the UK stock market is the best place for my money right now -- not least because buying overseas shares with a weak pound means that even if foreign markets do well, I could still lose out if and when the pound rallies against their currencies. This data from Goldman Sachs reinforces that view.

It's important to realise, though, that for this piece of research at least, Goldman isn't saying UK shares will definitely go up just because our government is cutting back. It's saying that going on prior history, UK shares will do better than the rest of the world during this period.

If shares everywhere go down the drain, floating above the morass may be of limited consolation!

This article was first published by The Motley Fool on17 May2010. Whether you're a seasoned investor or new to trading, The Motley Fool offers something for everyone. We tackle the tough investment questions and provide refreshing no-nonsense perspectives on everything from the global economy to investing strategy and in-depth company analysis. Sign up for our daily foolwatch e-newsletter and you won't miss a thing.