After one of the most turbulent and chaotic periods in British political history, UK stocks are now the cheapest on record compared to their global peers.
This could present a great opportunity for investors to buy some top-quality companies at depressed prices.
UK stocks are cheap – should you buy now?
I'll admit, it's pretty hard to come up with a good reason to buy UK equities right now.
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The country is facing one of the worst economic climates it has seen in over 50 years. The war in Ukraine shows no sign of abating and political infighting is only making the situation worse.
Still, this could present a great opportunity for those investors who are willing to go against the herd.
Last week, Barclays published a report showing that more money flowed out of UK equities this year than any other point on record. Investors have been pulling their cash from the country since the Brexit vote in 2016, although this year the trend has really accelerated.
The consistent selling has pushed UK equity valuations down to the lowest on record compared to global peers. According to analysts at JP Morgan, the average forward price/earnings (p/e) ratio of companies in the UK is 8.6 compared to 16.3 for the US.
Unfortunately, UK equities are likely to remain cheap until we know more about what’s going to happen next. Unless the country is able to pull it together and bring in a new prime minister that can bring stability to the Tory party, investors are likely to stay away.
Stability really matters to businesses and investors around the world. There’s been none of that in the UK this year.
Still, that doesn’t mean investors should avoid UK equities. There are some companies that look dirt cheap, but also generate most of their incomes outside the country.
These may be the businesses to target right now. The political turmoil has made them cheap, but they are unlikely to suffer if the UK economy enters a recession. If stability is restored, these companies are the most likely to gain confidence and international investors return.
Companies with more exposure to the rest of the world than the UK include catering group Compass, oil group Shell, financial services company the London Stock Exchange, consumer goods producer Reckitt and healthcare giant AstraZeneca.
What's next for UK stocks?
At the time of writing, it looks as if Rishi Sunak is set to become the new prime minister. The markets seem to like this idea. The value of the pound has rallied against other currencies and UK gilt yields have slumped.
Sunak will be able to take comfort from falling bond yields. His predecessor Lizz Truss was effectively thrown from office after the financial markets rejected her tax-cutting big-spending budget plans. Gilt prices slumped and yields jumped, hiking the cost of debt for the government and setting off a shockwave through the financial system. The Bank of England had to step in to reassure the market that it wasn't going to let the financial system collapse.
Gilt yields affect everything from mortgage costs to corporate bond interest rates, and a return to stability will be welcomed by the business community.
Of course, it's still early days for Sunak and as we have seen over the past month, a lot can change in just a few days.
For companies with less exposure to the UK (such as those outlined above), the state of the global economy will be far more important for growth in the long run.
And while the UK is facing multiple headwinds, it's not alone. All of Europe is dealing with an energy crisis and the US economy could be pushed into a recession as the Federal Reserve tightens monetary policy.
Still, in some respects, UK stocks have the edge here. There's already plenty of bad news baked into their valuations. That leaves room for upside if they outperform expectations.
If Sunak manages to stabilise the economy or if the projected recession does not turn out to be as bad as expected then equities could rally.
That said, if the slump is worse than expected, UK stocks may only get cheaper.
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