Seeking Alpha
Momentum, value/growth, long only, macro
Profile| Send Message|
( followers)  

Summary

  • The U.K. economy has recovered to post G7-leading GDP growth figures; this has produced fertile conditions for growth in the U.K. Stock Market.
  • The iShares MSCI U.K. Index faces major risks to growth, but many factors are priced in and the rest can be withstood with results expected even in current conditions.
  • There is huge upside potential if European and geo-political investment conditions improve.
  • In depth coverage of the U.K. economy shows that even in current conditions the index is still undervalued and provides a solid dividend with low risk.
  • This article also covers the risk to U.K. companies from the Ukraine crisis, China, weak European demand and rising energy prices due to geo-political unrest.

You don't have to look far to see a growing disquiet within the market suggesting that we could be due for a 20% correction anytime between now and next year. Although there are probably ulterior motives for some fund managers trying to get people to start withdrawing from the market, this period of sustained low volatility can be unnerving and it is therefore prudent to adequately assess the potential for growth away from the U.S. markets.

The U.K. has recently shaken off its recession and is set to become the quickest growing nation in the G7, backed by strong construction figures, growth and investment. Meanwhile, U.K. companies are showing their strength on the world stage and, when weighed up against the risks presented by Russia's aggressive foreign policy, rising energy prices, a possible interest rate rise and general weakness throughout the EU, they still present a compelling 'buy' case for U.S. investors.

A healthy U.K. economy paired with strength in the U.S., its main trade partner, is synonymous with growth in the U.K. stock market. However certain macro-economic risks stand between the U.K and sustained GDP growth in the long term. If a compelling case can be made for the strength of the U.K. economy (including areas crucial to the success of the most heavily weighted stocks represented in the iShares MSCI United Kingdom Index ETF (NYSEARCA:EWU)) despite the current economic climate; it can be assumed that EWU will enjoy long-term growth.

I'll cover the general health of the U.K. economy and the fundamental data that underpins it as well as the major macro-economic risks that stand in the way of sustainable long-term growth. Hopefully by the end I will have convinced you that the United Kingdom presents an undervalued growth opportunity in the form of the iShares MSCI United Kingdom Index.

(click to enlarge)

(Above) GDP Growth of the U.K. and Its Main Trading Partners. [Source: World Bank]

The (Excellent) Health of the U.K. Economy

1. Historically Low Unemployment Rates

The unemployment rate has been steadily improving over the last few years with an increase of 929,000 people in work bringing the total to 30.64 million.

The current employment rate, 73.1%, hasn't been seen since early 2005 and since records began in 1971 it has never been higher. This, combined with steadily increasing manufacturing productivity is definitely a good sign. Through the following charts we can gain an appreciation of what that means in terms of historic employment levels.

Although the unemployment rate has fallen dramatically, there has been no increase in wages for a long time. Whilst difficult for individuals, the EWU index will ultimately benefit when the slack produced by increased jobs is overtaken by employment figures closer matching jobs available. The resulting increase in wages should give consumers more spending power and further boost the market.

Employment Figures (Historic)

(Above) Historic Employment Rate (Percentage)

Employment Figures 2010+

(Above) Employment Rate Post-Crisis (2009-2014) [Chart 1.2]

2. Solid Manufacturing and Construction Data

Manufacturing was particularly affected by the recent recession, however it has sprung back to good health faster than many other sectors of the economy including services. From an output fall of 14.5% between Q1 2008 and Q3 2009 we can see in the chart below that manufacturing grew broadly in line with the rest of the economy at 3% over the previous year. The excellent recovery it has enjoyed can be most easily demonstrated by the chart below.

(click to enlarge)Manufacturing Growth Rates

(Above) U.K. Manufacturing and Growth Rates Between 1998 and 2014

As construction, based on 2010 weights, accounts for 6.3% of total GDP it should be given due consideration when determining the sustainability of the U.K.'s long-term recovery. It is for this reason it is sometimes used as a standalone economic indicator.

Although the figures, as detailed in the chart below, show a month-on-month output fall of 1.1% in May 2014, it is still 3.5% higher than in May 2013 and is consistent with wider GDP growth. This was further supported by the third consecutive month of new housing output with a growth of 1.1%.

Even with the latest drop of 1.1% in May 2014, it is still broadly higher than the construction output figures for both the Euro Area and the EU 28.

Despite these depressed figures there was 0.8% GDP growth posted for Q1 of this year. This suggests that there is still some way for the GDP to run when construction output really takes off.

(click to enlarge)

(Above) All Construction Work; Monthly Time Series Chained Volume Measures (Seasonally Adjusted)

3. Strong GDP Growth

As mentioned previously, GDP increased by 0.8% in both Q1 and Q2 of 2014. Rather than throwing numbers at you describing how each of the constituent parts of the GDP calculation has grown recently I've drawn up the following chart so you get a good idea of how it has moved without getting lost in the numbers. It's pretty clear that the post-2012 growth is backed by strong data across the board.

In the short term it is likely that the strong figures posted for the first half of the year will be matched by equally strong figures for Q3 boosted by an increase in consumer spending fueled by summer-sales. Equally, when production and construction catch up to services and agriculture we could see a further boost to GDP.

(click to enlarge)

(Above) United Kingdom GDP and Main Components [Data source: U.K. Office for National Statistics]

4. The Growth of the United Kingdom's Main Trading Partners.

Painting a picture of a rosy domestic market goes some way to supporting prospects for sustained future growth however if this isn't backed by strong exports and demand it doesn't tell the whole story. I've therefore aggregated import and export data comparing the year-to-date 2014 to the same period last year.

(click to enlarge)

(Above) U.K. General Trade Exports for YTD 2014 vs YTD 2013.

(click to enlarge)

(Above) U.K. General Trade Exports YTD 2014 vs YTD 2013.

The above charts tell the story of an overall decrease in both imports (1%) and exports (14%). Although the export decrease is disproportionately affected by the outlier in the Switzerland trade data the general outlook is that weak global and domestic demand has depressed both figures.

The positive here is that despite flat exports and imports the economy was able to grow quite substantially over this period. This bodes well for the U.K.'s ability to deal with the continued weakness displayed by some of Europe's other economies.

Macro-Economic Risks To Future Growth of the U.K. Markets

It is impossible to come to a fair conclusion on the future direction of the stock market without giving due appreciation to the factors that, to a greater or lesser extent, stand between the United Kingdom and sustained long-term growth rivaling that of the United States.

1. Rising Energy Prices

From Gaza to Libya the Middle East is in an almost constant state of turmoil and, at risk of insensitively distilling it into a financial consequence, we are therefore unlikely to see a significant drop in energy prices in the short to medium term. Equally, unless we see a new major increase in violence across the OPEC nations there is an equally small chance we'll see an increase in prices of the magnitude required to stall the growth of the U.K. market.

This sustained period of increased oil prices is obviously good for the oil majors British Petroleum (NYSE:BP) and Royal Dutch Shell (NYSE:RDS.A) which are heavily weighted within the EWU index.

However to explore the downside risk of sustained high energy prices to the other members of the EWU index we should look at the historic energy prices and how they've moved in the context of the U.K.'s recovery thus far.

(Above) Price Movement Between Q1 2013 and Q1 2014 by Size of Customer

It can be seen that heavy fuel oils have dropped in price across the board whilst electricity and gas for large customers has also dropped. This is likely to have had a positive effect regardless of the increase for small and medium customers and, for the purposes of making a case of the high-cap stocks in the EWU index, will show itself in decreased operational expenditure over the coming year.

This tells part of the story, the rest is shown by the gradual increase in energy prices below.

(Above) Price for major energy sources in pence per kWh.

Unlike the United States where energy is in relatively plentiful supply, the United Kingdom has factored expensive energy prices into running costs for some time. We can see that energy prices have risen quite substantially through the period 2010-2014 and during the same time GDP was able to grow equally substantially, allaying fears of the possibly detrimental effect that high energy prices would have on future growth.

Recently oil prices rose during June in response to unrest in Iraq but prices have since fallen back. The fact that the price of oil has remained in a tight range around $110 per barrel since 2012 despite so many different risk factors coming to light over this period lends some weight to the argument that it is unlikely to increase significantly past this point in the future. It is even possible that as these problems reach a conclusion, combined with a possible start to exports from the U.S., we could see a drop in oil prices in the long term.

Additionally, the U.K. government has set about the business of dividing shale oil and gas drilling licenses across England, Scotland and Wales. Although at the moment there have been no substantial commercially viable discoveries, it is a matter of time before the industry picks up. In the long term it is unlikely to drive the kind of growth we've seen in the U.S. markets, however it should keep growth from reaching the point of inflexion where it is held back by expensive energy prices.

2. Interest Rate Rises

The current level of cheap credit is not going to last forever and so the effect of the inevitable rise in interest rates on the EWU index's main players should be considered.

The Bank of England's own guidance this month states that any rate rise in the medium term is likely to be very small and will not have an adverse effect on investment. Although it might force a pullback in the housing market, it is not expected to have a similar effect on the markets.

This is supported by the view that an interest rate rise in the short term could come too soon and instead of catching inflation at the target rate, it could derail the recovery and leave inflation below target.

(click to enlarge)

(Above) Consumer Price Inflation June 2004 to June 2014

3. Russian Foreign Policy

The downing of MH17 has irreversibly changed the landscape of the conflict in Ukraine. The resulting sanctions that have been put in place by the U.S. and the EU have targeted a number of industries, however each has been careful not to indirectly or directly disadvantage their, in some cases quite fragile, home markets.

With regard to the EWU index BP and Shell each have exposure to the Russian oil giant Rosneft, however they are both experiencing huge growth across the board. Although in the short term the uncertainty over Russia is adversely impacting their share price, the sanctions don't hugely affect Rosneft's production capabilities - only their ability to borrow money.

BP has a 20% stake in Rosneft and relies on it for 8% of its income however in anything short of a ban on holding equity in Russian companies, which currently seems unlikely, shouldn't put this stake in jeopardy. Combined with the fact that BP already trades at a 20% discount to the rest of the sector it has the potential to have a hugely positive effect on the index of which it represents 5.12%.

Jefferies analyst Jason Gammel, writing about BP:

BP delivered strong cash generation and significant improvement in Upstream profitability in Q2, particularly in the U.S. - and it was completely overshadowed in the market by an increased perception of Russian risk. While we believe that there is nothing in the EU sanctions that detract from neither Rosneft's ability to do business nor BP's ability to exercise its shareholder rights in the company, the required risk premium appears to be increasing on Russian assets. BP's equity stake in Rosneft has a current market value of about $13 billion, about 8.5% of BP's total market value - and when headlines lead to market doubts about the ability to do business in Russia it will be difficult for BP's stock to perform well.

The rest of the index is not overly exposed to the Russian market and it is possible that it could benefit from the huge capital outflows from Russian stocks. It is more than likely that a portion of the capital taken from Russia will be reallocated into U.K. shares given the underlying strength and stability of the economy.

5. The Collapse of the Chinese Shadow Banking Sector

With a complete collapse in global demand for Chinese goods and services as a result of the 'Credit Crisis' the threat of recession loomed large over the Chinese economy. In response, the ruling Communist Party started a monetary easing policy the extent of which had never been seen before. To put into perspective the amount of money they distributed into state-owned companies from state-owned banks; they replicated 100 years of growth in the U.S. banking industry in 4 years.

When the monetary policy advisors realized that the easy credit was, in addition to doing a fantastic job of buoying the economy, leading to the lending of money to questionable debtors they turned off the tap. However the tap didn't turn off and credit continued to be doled out. This indiscriminate lending led to what has been touted as a coming debt crisis.

(click to enlarge)

(Above) Figures for Chinese Debt as a percentage of GDP.

It is unlikely that there's an imminent crisis for China for a number of reasons. Firstly, over 60% of the economy is state-owned and most of the debt is to internal creditors therefore it is unlikely that a bank will trigger a wave of defaults by calling it in. Being state-owned, there is also theoretically no limit to the amount of bad debt that can be written off by the government without anyone going out of business. Secondly, the level of debt is still below that of several European countries at the time of the credit crisis such as Ireland (400%) and Greece (260%).

Still, two key parts of the EWU index, HSBC (NYSE:HSBC) (6.95%) and Standard Chartered (1.75%), are heavily involved in Asia with Standard, a predominantly Asian bank, likely to be damaged the most if there is a Chinese debt crisis.

In response, Standard Chartered has been re-assessing its portfolio over the last few months leading to an adverse effect on results - seen by some as poor management it will pay off hugely if problems arise. This, alongside plans to preserve capital by scaling back expansion plans, should hold Standard in good stead.

HSBC has also acknowledged the risk of some unavoidable defaults but their exposure to bad debt is minimal and it is believed that:

A number of credit defaults across Asia are likely to encourage future fiscal prudence, which is long-term positive for the region. HSBC had an industry leading tier one capital ratio of 13.6% at the end of the first quarter and the bank continues to de-lever its portfolio.

A Quick Look At The iShares MSCI United Kingdom Index

The shares I haven't touched on already that hold a high weighting in this index include GlencoreXtrata (OTCPK:GLNCY) (Boosted by higher commodity prices), Vodaphone (NASDAQ:VOD) (Global reach) and GlaxoSmithKline (NYSE:GSK) (Simplifying its revenue streams).

For more technical data I would like to quote another recently published article on this ETF:

The global nature of these megacaps helps limit overall risk exposure as evidenced by the fund's beta of 0.91.

From a valuation standpoint, current data suggests that this region is undervalued. The United Kingdom ETF has a trailing 12-month P/E ratio of just 14 - about 15-20% below its long-term multiple. Additionally, its current price/book ratio of 1.89 and price/sales ratio of 1.05 both indicate a portfolio that is cheap on a relative basis. Year-to-date, the iShares MSCI United Kingdom ETF is relatively flat but has outperformed the FTSE 100 in the most recent one- and two-year periods.

Adding to the potential of this ETF is the current 2.6% dividend yield that comes with the fund. Historically, the dividend yield has been nearer to 3% and has occasionally pushed the 4% level. The drop in yield could be at least partially explained by the performance of the ETF itself, which has returned almost 15% since the beginning of 2013.

Conclusion

The potentially strong growth of the iShares MSCI United Kingdom ETF is underpinned by a very positive outlook for the U.K. economy as a whole with wider risks such as the weakness of the Eurozone unlikely to be able to drag the U.K. back into recession. Other risks such as geopolitical unrest are already priced into the stocks represented in this fund and therefore there is a huge upside potential for this growth/value play. The range of investments represented in this index also provide exposure to a number of industries whilst being diverse enough to weather potentially choppy financial waters over the coming year.

Source: Whilst Mainland Europe Is Stalling, The iShares U.K. Index Is Preparing To Take Off