- Even as dividends on the MSCI U.K. have seen drastic cuts, the index’s dividend yield remains more than double the MSCI World at a healthy 4.5%.
- The EWU ETF looks set to benefit from cheap valuations, the recovery in resource prices, and the potential for pound sterling appreciation.
- In terms of relative value, Amazon, Netflix, and Tesla combined have a market cap similar to the entire U.K. market despite the latter having over 16 times the net assets.
- The solid fundamental outlook is coupled with a recent improvement in the technical outlook. Most notably, we have seen the equally-weighted FTSE 100 considerably outperform the market-cap weighted index.
We noted during the height of the market crash on March 22 that U.K. stocks were trading at bargain levels which left them highly likely to generate strong returns over the long term, particularly relative to U.K. bonds and the MSCI World, owing in part to the overvalued nature of U.S. stocks. Since then the iShares MSCI U.K. ETF (EWU) is up ~30% but has still underperformed most of the rest of the world as earnings estimates and dividends have collapsed. However, even as dividends on the MSCI U.K. have been cut by roughly 27% (in line with the decline seen during the Great Recession), the index’s dividend yield remains more than double the level of the MSCI World at a sizeable 4.5%. Cheap valuations and high dividend yields should make for strong outperformance over the coming months and years, particularly if inflation pressures return. The improvement in market internals suggests that the recent recovery remains well supported.
Energy And Financials Have Taken A Beating
EWU’s underperformance has come largely due to the weakness in two key sectors – Energy and Financials – which prior to the crash made up over one-third of the entire MSCI U.K. Meanwhile, dividend cuts in these sectors have been responsible for over half of the entire index’s dividend declines. The following chart shows the MSCI U.K. index broken down into the Energy and Financials sectors and everything else.
Source: Bloomberg, Author’s calculations
With oil prices recovering strongly from the April plunge, we expect BP (NYSE:BP) and SHELL (NYSE:RDS.A) (NYSE:RDS.B), which together represent the entire MSCI U.K. Energy sector, should follow suit. We wrote last month (see ‘XLE: Energy Stock Comeback Has Begun‘) how we believe the combination of cheap valuations, high dividend yields, and a cyclical recovery in oil prices should benefit U.S. energy equities and the same goes for the U.K. These stocks have failed to join in the global risk recovery to a large extent and are now close to the cheapest they have ever been relative to the MSCI World Energy index and crude prices themselves.
U.K. Energy Index Vs. World Energy Index (Dividend Yield)
As for the financials, almost one-third of the decline in the MSCI U.K. Financials index since February has resulted from the decline in HSBC (NYSE:HSBC). The bank’s dividend cuts at the behest of the Bank of England as well as expected losses from the Covid-19 lockdowns and rising concerns over the future of Hong Kong as a global financial centre have hit the bank from all sides. HSBC’s market capitalization is now a record low 1.6% of the MSCI World Financials index and it is trading at half of the index in terms of its price-to-book value. We do not have a particularly strong view on the bank but it would seem at the very least like a lot of future fundamental underperformance is already priced in.
Valuations Still Attractive
For the index as a whole, even after such a sharp decline in dividend yields, it remains the highest yielding major index globally. It also trades at a record discount to the MSCI World in terms of its price-to-sales, price-to-book, and enterprise value-to-EBITDA ratio. Undervaluation on these more slow-moving metrics (as opposed to price-to-earnings ratios) generally tends to result in strong long-term performance owing to the mean reversion in profit margins and return on equity that takes place over the long term. If global inflation rises as we expect for reasons explained here, the Energy and Materials sectors, which together make up a fifth of the index by weighting, should perform particularly strongly.
Cheap Pound Another Reason For Optimism
Another attractive feature of the EWU is that the pound is also undervalued based on both the short-term trend of GBPUSD relative to real bond yield spreads and the long-term real interest rate trend. While a high degree of the index’ revenues is in dollar-based operations, any recovery in the pound would still benefit earnings in dollar terms of the ~30% of the index’s revenues that come from the U.K.
A Bird In The Hand Is Worth Two In The Bush
While U.K. stocks have been hit particularly hard by recent events, investors have flooded into U.S. technology stocks. As a result, the MSCI U.K. is now worth the same as a handful of U.S. tech stocks. In fact, Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Tesla (NASDAQ:TSLA) combined have a market cap of just less than the entire U.K. market despite the latter having over 16 times net assets. Furthermore, the MSCI U.K.’s trailing 12-month dividend payments have actually exceeded the tech trio’s entire net assets. Even trailing earnings were 7 times higher in MSCI U.K. compared to the three tech stocks despite the latter’s recent sales boom.
Source: Bloomberg, Author’s calculations
It could well be the case that these three tech stocks continue to grow sales, rapidly allowing profits and returns on equity to surge and investors to see strong cash flows via buybacks and dividend payments. However, a lot of things need to go right in order for these and other U.S. tech stocks to generate positive returns. We would need to see sales rise rapidly for years to come in a stagnant economy without any downward pressure on margins. On the other hand, for U.K. stocks to yield positive returns all that would need to happen is for the global economy to avoid a prolonged deflationary depression. In other words, we think a bird in the hand is worth two in the bush. Given the extreme level of uncertainty facing the global economy, we believe that low duration (or high dividend-yielding) equity markets should outperform.
Technical Outlook Improving
The solid fundamental outlook is coupled with a recent improvement in the technical outlook. Most notably, we have seen the equally-weighted FTSE 100 considerably outperform the market-cap weighted index. While U.S. equity indices have been dragged up by a handful of tech stocks, U.K. stocks have been dragged down by a handful of resource and financial stocks. The following chart shows the average stock has recovered much more strongly and the ratio of the market cap-weighted to the equality-weighted index is closing in on record highs.
FTSE 100 Vs. FTSE 100 Equally-Weighted Index
In addition, we have seen new highs in the on-balance volume index, which shows that volume is flowing into the market. Finally, from a sentiment perspective, the U.K. remains a highly contrarian market with the June BofA Fund Management Survey showing that investors are more underweight U.K. stocks than any other sector with the exception of energy.