Europe Outside The Eurozone - The U.K.

by: David Kotok

by Bill Witherell, Chief Global Economist

While the market is focusing on the prospects for full-scale quantitative easing in the Eurozone and the continued decline of the euro, there are major European equity markets that do not have the euro as their currency and whose monetary policy is independent of the European Central Bank. The foremost of these is the U.K. equity market, which is the largest in Europe, with only those of Japan and the USA being larger among the advanced-economy markets.

The U.K. economy last year grew at an estimated 3% pace, far faster than the Eurozone’s 0.9% rate and, outside the zone, Sweden’s 1.8% advance and Switzerland’s 1.9% growth. U.K. equities did not reflect this economic outperformance. According to total returns calculations by Credit Suisse, the local currency return for U.K. equities in 2014 was 1%, compared with 14% for Swedish equities, 13% for Swiss equities, and 3% for German, French, and Italian equities. U.S. dollar-based investors saw returns some 5% less as a result of the strengthening of the U.S. dollar versus the pound sterling. Will that underperformance continue for U.K. equities in 2015?

The headwinds that affected U.K. equities in the second half of 2014 after their peak in late June are still present at the start of 2015. Foremost were concerns about the economic slowdown in the European Union, which accounts for 48.5% of the U.K.’s exports. Those concerns remain for investors, with fears about Greece being foremost at present. The latest Eurozone Manufacturing Purchasing Managers’ Index showed manufacturing remaining stagnant at year-end. Service sector growth also remained subdued. However, we have a positive view of the prospects for the Eurozone economy this year, with the pace increasing each quarter and reaching 2% by the fourth quarter, a rate that is double the estimated trend rate of slightly below 1%. This, together with strong growth in the U.S. economy, the U.K.’s second most important export market, should permit U.K. exports to grow by over 3%, in contrast to last year’s 1.5% decline.

Another concern has been the steep drop in the oil price and its possible effects on the U.K., which is an oil exporter. While there will certainly be negative effects on the energy sector, which has a weight of 15% in the broad-based iShares MSCI United Kingdom ETF, EWU, these will be heavily outweighed by the positive effects of lower oil prices – reducing production costs across a number of sectors and boosting household spending power. These positive effects will also be important in the U.K.’s export markets.

Profit warnings during 2014, issued at the highest rate since the financial crisis, were also a factor driving down equities in the second half. The profit outlook for 2015, however, is better as companies benefit from lower costs and a pickup in the pace of economic activity, reversing the slowdown that characterized the closing months of 2014. The consumer, intermediate, and investment goods sectors ended the year on a solid basis; and the one weak area, exports, looks likely to improve going forward. Overall GDP growth is projected to maintain a strong 3% annual pace in the current quarter and to remain close to that rate for the remainder of the year. A projected dividend yield of 3.8% is another positive consideration, along with a likely increase in takeover activity.

The too-close-to-call general election scheduled for May 7 may well lead to market volatility in the coming months. This possibility presents a near-term political risk to both equity markets and sterling. However, the risk is limited that the Bank of England (NYSE:BOE) will move to raise interest rates earlier than the markets expect. The BOE, apparently satisfied with the current stance of monetary policy, took no action at its meeting last week and decided that publishing a formal statement at this time was not warranted. Low inflation in the U.K., even though caused in part by the external factor of oil price declines, will make it difficult for the BOE to raise interest rates for some time, perhaps not until next year. That will likely be later than the Fed moves in the U.S. This likelihood suggests that some further easing of sterling versus the U.S. dollar lies ahead, which would cut into U.S. dollar returns from U.K. investments unless hedged.

In sum, while there are good reasons to expect U.K. equities to recover from their slump in the second half of 2014, there are also risks, particularly for U.S. dollar returns that are not hedged to protect against a further decline in sterling. Cumberland’s International and Global equity ETF portfolios are presently underweight with respect to the U.K. We will be monitoring the situation closely.

Disclosure: No positions