EWU: U.K. Stocks Breaking Out
Summary
- We continue to hold outsized long positions in U.K. stocks via the iShares MSCI United Kingdom ETF due to a combination of strong price action and deeply discounted valuations.
- Down trendline resistance from the 2018 highs has given way which brings into focus the USD32 area. A break above here would suggest a run at the USD35 area.
- The median U.K. large cap stock continues to outperform capitalisation-weighted indices which we see as a sign of internal market strength.
- On a relative basis, U.K. stocks are incredibly cheap, compared to both developed and emerging market benchmarks. On a forward PE basis, the MSCI U.K. trades at a 35% discount to the MSCI World and a 12% discount to the MSCI EM, with the current discount the largest in over a decade.
- Despite large cap U.K. stocks deriving most of their revenues from overseas operations, the ~30% of revenues derived from the U.K. should be supported by the ongoing reopening of the U.K. economy as the Covid vaccination programme remains on track.
We continue to hold outsized long positions in U.K. stocks via the iShares MSCI United Kingdom ETF (NYSEARCA:EWU). U.K. stocks remain the most attractive among developed market indices in our view, and the EWU, which tracks the MSCI UK Index, offers a relatively low cost and liquid vehicle to participate in the ongoing recovery. The EWU's uptrend from the 2020 lows remains intact and the index is on the cusp of a meaningful upside break. Forward estimated revenue, earnings, and dividends are all showing strong recoveries and the index's valuation gap relative to the rest of the world has risen to new multi-year highs. While the majority of the FTSE 100's revenues come from overseas, the collapse in Covid-19 cases and deaths bodes well for the reopening of the domestic economy.
Market Technicals Remains Positive
The EWU's recovery from the March 2020 low remains firmly intact and down trendline resistance from the 2018 highs has now given way. This brings into focus key down trendline resistance around the USD32 area. A break above here would lend further support to the chart pattern and open up a run at the USD35 area.
iShares MSCI United Kingdom ETF
Source: Bloomberg
If we look at the MSCI U.K. itself, which is denominated in pound sterling rather than dollars in the case of the EWU, it has underperformed of late but looks to be tracing out a bullish flag pattern. Yesterday's break above the GBP1900 level brings lateral resistance around GBP2000 into focus.
MSCI UK Index
Source: Bloomberg
The average U.K. stock has been dramatically outperforming reflecting the relative underperformance of the largest companies on the index. The chart below shows the performance of the market cap-weighted FTSE 100 versus the equally-weighted FTSE 100. The latter is now at record highs, as is the ratio of the two. Generally speaking bull markets do not end with such strong market internals so we see this as reason to expect continued gains.
FTSE 100 Vs. Equally-Weighted FTSE 100
Source: Bloomberg
Forward Looking Valuation Metrics Remain Relatively Cheap
While U.K. stocks have been rising, earnings expectations have actually been rising at an even faster pace. As a result, the Bloomberg forward PE ratio for the MSCI U.K. has fallen to a multi-month low of 13.6x, while the forward EV/EBITDA ratio has fallen to 8.1x. These figures are admittedly high relative to historical averages but with sales and earnings continuing to recover we should see continued downside pressure on valuations in the absence of continued equity price gains.
The expected recovery in profitability bodes well for dividend payments which have begun to bottom out after their 45% peak-to-trough decline. The trailing 12-month dividend yield currently sits at 3.6% while the forward yield is 4.0% reflecting strong expectations for dividend growth over the coming months.
On a relative basis U.K. stocks are incredibly cheap, compared to both developed and emerging market benchmarks. On a forward PE basis the MSCI U.K. trades at a 35% discount to the MSCI World and a 12% discount to the MSCI EM, with the current discount the largest in over a decade.
Forward PE Ratios: MSCI UK Vs. MSCI World and MSCI EM
Source: Bloomberg
The forward dividend yield picture shows U.K. stocks are even more discounted on a relative basis, with the forward dividend yield more than double the MSCI World and over 70% above the MSCI EM.
Forward Dividend Yields: MSCI UK Vs. MSCI World and MSCI EM
Source: Bloomberg
Commodity Stock Weakness Should Prove Temporary Amid Rising Inflation Expectations
In early February we noted materials and energy stocks make up over 20% of the MSCI U.K. and should be expected to perform well during inflationary periods even as margin pressures weigh on other sectors. As the chart below shows there is a close correlation between U.S. breakeven inflation expectations and the relative performance of commodity stocks in the MSCI U.K. Since February we have actually seen commodity stocks underperform despite the ongoing rise in inflation expectations but we do not expect this to continue for much longer.
Source: Bloomberg, Author's calculations
U.K. Reopening On Track
Despite large cap U.K. stocks deriving most of their revenues from overseas operations the ~30% of revenues derived from the U.K. should be supported by the ongoing reopening of the U.K. economy. Roughly 60% of the U.K. population has been vaccinated and both cases and deaths have collapsed in recent weeks, keeping the government's reopening timeline on course. This contrasts with the picture in the rest of Europe where cases and deaths have recently begun to pick up.
Total Covid Deaths In U.K. Vs. Europe
Source: Bloomberg
GBP Strength Yet To Feed Into EWU Outperformance
In previous articles, we have noted an additional tailwind to the EWU in the form of sterling strength. As the EWU is denominated in U.S. dollars, strength in the pound adds to dollar-based gains all-else equal. With U.S. - U.K. real interest rate spreads heading back in the U.S.' favor over the past month the case for GBP strength is not as strong as it was previously. That said, the fact that EWU has still underperformed global stocks despite sterling's strong gains over the past year reflects just how relative undervalued U.K. stocks have become compared to the U.S.
This article was written by
Analyst’s Disclosure: I am/we are long EWU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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