Why UK stocks won’t be cheap for much longer

The fading threat of negative interest rates, the resumption of dividends, and the rotation away from tech stocks towards cyclical businesses will all boost UK stocks.

The British economy is poised to enjoy its fastest growth in over 70 years, according to the latest Bank of England forecasts. A successful vaccination programme and continued government fiscal support should help GDP expand by 7.25% in 2021, the fastest pace since at least 1949. The Bank also thinks unemployment will peak at 5.5% this year, a big cut from its previous forecast of 7.75%. 

Strong growth means no negative rates

British stocks surged on the update, with the FTSE 100 topping 7,100 to hit a post-pandemic high last Friday before falling back amid this week’s global sell-off (see below). The index has gained 6% since the start of the year, while the mid-cap FTSE 250 index is up by 8%. 

“Let’s not get carried away,” says Bank governor Andrew Bailey. Strong growth is to be expected as the economy recovers from a 9.9% contraction last year, its biggest decline since 1709. The Bank now expects UK GDP to return to pre-pandemic levels by the end of this year, but that still means that “two years of output growth have been lost”. This is a rebound, not a boom. 

The Bank held interest rates at 0.1% last week. It doesn’t expect to raise them until the end of next year. At the start of the year the debate was about whether we were heading for interest rates below zero, notes Laith Khalaf of AJ Bell. The Bank is still doing technical work on the idea, but it has turned into “a purely academic exercise”. Instead, the talk now is about when rates will rise; markets currently price in a 25% chance of a hike over the next 12 months. “Negative rates are… dead before arrival.” 

Dividends recover

UK income investors have endured a 41.6% fall in dividends over the year since the pandemic began, a loss of £44.8bn, according to data from Link Group. Dividends continued to fall in the first quarter, but Link notes that the pace of reductions is slowing. “Half of UK companies either increased, restarted or held their dividends steady” during the first three months of the year. The return of payouts from big banks means Link now expects underlying dividends to grow 5.6% this year to £66.4bn. Special payouts from Tesco and commodity miners mean the “headline” numbers will be even better. 

The UK market has been one of the cheapest in the developed world in recent years and currently trades on a cyclically adjusted price/earnings (p/e) ratio of about 14.5. The UK discount is finally starting to “unwind”, says Lex in the Financial Times. Simon French of Panmure Gordon calculates that the “valuation gap with the rest of the world” (as measured by price/earnings and other metrics) has fallen from 20% in 2020 to 15% now. 

The ratification of the post-Brexit trade deal with Europe removes one “red flag” that has stopped global money managers from buying British. The ongoing rotation away from tech stocks and towards cyclical energy and financial businesses also plays to London’s strengths. “UK stocks will not stay cheap for much longer.”

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