An Upgrade Of U.K. Equities

Includes: EWU
by: Russ Koesterich, CFA

Based on a number of recent developments, I’m upgrading my view on U.K. equities. Not only am I now less bearish on the region’s future growth, but I also believe U.K. equities can act as a diversifying asset because the U.K. tends to exhibit low correlations with countries in the eurozone. Investors may now want to consider moving to a neutral or market-weight position on stocks from the United Kingdom.

I first suggested to investors that they adopt an underweight position to U.K. equities in mid-March. At the time, I was concerned that the United Kingdom’s valuation did not reflect the deteriorating growth outlook for the country. Since then, UK growth has indeed slowed: Gross Domestic Product (GDP) contracted by 0.20% in Q1 and by 0.5% in Q2, putting the U.K. technically back into a recession.

But my views have changed for the following reasons:

  • First, I’ve become less bearish about U.K. growth going forward than I was six months ago. While I still think the UK’s growth will be less than the growth of many other developed countries, including the United States, currently our in-house model sees a slight contraction in U.K. economic activity at -0.1% year-over-year, which is an improvement from our previous view of a -0.6% contraction. This modest upward revision is consistent with recent positive data surprises, as shown by upbeat retail sales and a firming labor market.
  • Second, the Bank of England (BOE) has been one of the world’s most aggressive central banks in easing monetary conditions. Over the past three years, the BOE has purchased more than 325 billion GBP of U.K. assets, a significant number relative to the size of the market and economy. This aggressive monetary easing, coupled with a new program designed to encourage loans to households and businesses, should help mitigate further economic weakness.
  • Finally, the U.K. is outside the euro, and has a relatively low correlation with countries in the eurozone. As such, the U.K. represents a diversifying position compared to countries on the continent.

In addition, the U.K. can be considered a defensive market and has a large service sector, accounting for more than 75% of GDP. In other words, despite its geographic proximity, the U.K. is relatively more insulated from Europe’s woes than many other countries.

While I am still wary of the U.K.’s prospects, all of the above suggest that its benefits as a diversifying asset may now outweigh its negatives. I would therefore advocate that investors no longer be underweight the U.K. and instead move to a neutral or market weight position on U.K. equities.

For investors interested in the equities market in the U.K., one way to access that is through the iShares MSCI United Kingdom Index Fund (NYSEARCA:EWU).

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