22 March 2019
That Brexit has provided investors with a long-term opportunity in UK shares is now a widely discussed topic. A sweetener is that the already-attractive dividend on the main benchmark index is largely paid out of cashflows earned in currencies other than sterling, partially hedging against domestic currency weakness. Importantly, the reluctance of investors to take on the uncertainty that comes with UK shares in favour of more expensive but more predictable regions has similarities to a number of other markets.
For the last few years, investor preference has been for capital preservation as much as, if not more than, capital gain. Some of this may be down to the increasing number of ageing savers. But there is also a sense of economic and systemic fragility in the wake of the financial crisis that has resulted in a deep aversion to loss and volatility. The predictable now commands a rich premium relative to the uncertain. There is even a case to be made that this has extended to recent investor preferences for illiquid asset classes such as private equity, private debt and infrastructure, where the absence of short-term price discovery reduces the volatility they are subjected to.
Indices calculated in dollars. Source. Refinitiv, Fidelity International, March 2019.
In public markets, the areas that have attracted the biggest discounts have been those where uncertainty has been highest: recent elections in Brazil, the shape of the Chinese economy where trust in published data is low, value stocks in the US where ‘cheap’ has become a euphemism for ‘failing’, and of course the impact of Brexit on UK shares. For much of the last decade, valuation has been a very poor predictor of future returns as this polarisation between the predictable and uncertain has extended.
But this bifurcation will not go on forever. Beyond short-term investment preferences and the higher participation of price-insensitive actors (central banks, passive strategies), prices will eventually converge to fundamentals. Moreover, it is likely that many of the areas that investors have rushed to for safety may prove far less predictable over time, whereas those areas of high perceived uncertainty may have already discounted a good part of the possible downside. This is especially true when taken at the level of an overall benchmark rather than a single security.
When it comes to the UK, investors would be well served by taking the ‘outside view’. Rather than get stuck in the intricacy of what will in any eventuality be a process without a clear conclusion, look at the uncertainty around Brexit as an instance of a wider reference class. We see good value in UK shares as we do in other areas where medium-term uncertainty is high.
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