Is the UK now a buy? Analysts weigh in after market meltdown

Is the UK now a buy? Analysts weigh in after market meltdown

A security guard stands outside the London Stock Exchange building on December 29, 2020.

Tolga Akmen | AFP via Getty Images

U.K. bond markets and the pound went into freefall this week as investors balked at the new government’s fiscal policy announcements, and some analysts believe opportunities are arising.

The Bank of England on Wednesday was forced to intervene in the bond market with a temporary purchase program, as the capitulation of long-dated gilt prices threatened pension funds and mortgages, posing what the central bank deemed a material risk to financial stability.

U.K. bond yields are on course for their sharpest monthly incline since at least 1957, while the pound fell to an all-time low against the dollar on Monday.

Viraj Patel, senior strategist at Vanda Research, told CNBC on Wednesday ahead of the announcement that the next few weeks would be critical for investors assessing whether to go back into U.K. markets, but he would not consider it yet.

“The pound six days ago was not an issue for me. I was looking at a range of other currencies as being more dislocated in markets right now,” Patel said.

He added that the fall in the currency and British bonds represented a vote of no confidence in the government’s fiscal package, and concern about where sustainable growth is going to come from in an environment of high and rising short-term interest rates.

UK stocks are less attractive given high bond yields, says analyst

“I think some of these doomsday fears are being somewhat overblown to some extent, but I don’t think anyone wants to step in right now and buy undervalued U.K. assets at this point,” he said.

“We could have a different conversation in three months because the pound is extremely cheap, but I think that it’s just one of those things where it’s the storm before the calm.”

The U.K. stock market has also sold off in recent sessions, though not to any deeper extent than other markets across Europe amid a broad global pullback for stocks, as fears of more aggressive monetary policy tightening from central banks and slowing growth force investors to the sidelines.

Alan Custis, head of U.K. equities at Lazard Asset Management, told CNBC on Thursday that the general sale as a result of the country’s economic turmoil “does in a way throw up some opportunities” for British blue chips with overseas earnings who benefit from a falling pound.

Stock analysts watching gilts closely

British long-dated bonds – known as “gilts” – have seen historic levels of volatility in recent days, with prices rallying from their initial collapse on the back of the Bank of England’s announcement that it would buy long-dated bonds for two weeks and delay next week’s scheduled gilt sales until Oct. 31.

Custis said stock analysts were closely watching the volatility in gilt markets for indications as to where interest rates are likely to go.

“The market is now discounting interest rates going up towards 6%. Before this situation last week, we were probably thinking 3.75, maybe 3.5% would be the peak, inflation peaking maybe October or November this year at around 11%. Now clearly, that’s been thrown out, because we don’t know where sterling is going to go, how inflationary a weak sterling could be for the economy,” Custis said.

“Stability in the gilt market is very important for those reasons, because it can give us some sense as to where interest rates may ultimately land, and obviously that will have a big impact on mortgage rates and consumer spending, so it’s all linked in, so yes, we watch the gilt market just as much as we watch the equity market.”

Strategist says it's questionable whether UK stocks will offer returns compared to the U.S.

Britain’s blue-chip FTSE 100 is renowned for its high dividend yields for investors, but with bond yields soaring, the attractiveness of these kinds of stocks is diminished, Custis acknowledged, but he highlighted that 45% of the dividends paid by companies on the index are paid in dollars, which insulates it to a certain extent.

This would also help explain why Britain’s mid-cap FTSE 250 index has had a tougher run in light of the country’s economic chaos and currency collapse than its large-cap cousin.

“When we saw it with the real estate companies over the first couple of days of this week, (capitalization) rates in real estate stocks are four and a half percent – if you’ve got interest rates at 6%, it’s very difficult for real estate stocks to look attractive.”

Central to the outlook in the near future, analysts have suggested, is for Finance Minister Kwasi Kwarteng to re-establish credibility, after taking the rare step of omitting forecasts from Britain’s independent Office for Budget Responsibility prior to Friday’s controversial announcements.

Kwarteng has promised a more detailed and costed implementation plan on Nov. 23, while the Bank of England meets on Nov. 3 to appraise the impact of the fiscal announcements and determine the scale of its next interest rate hike.

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“I think we need to see the OBR, the Bank of England and the Chancellor come together and again reinforce the financial prudence, the tramlines, the aim to reduce debt-to-GDP numbers – albeit we’re in quite a strong position at the moment,” Custis said, adding that a joint statement in November would be a positive signal for markets.

Although some analysts have highlighted that the U.K. retains strong fiscal fundamentals and support barriers for bonds and the currency, many are reluctant to jump back in until the smoke clears.

Seema Shah, senior global investment strategist at Principal Global Investors, said investors were assessing whether the U.K. still holds up as an attractive long-term investment destination alongside other developed economies.

“Whereas for the U.S., I think it’s a resounding yes over the next 10 years – equities will be higher than where they are today,” she told CNBC on Wednesday.

“For the U.K., it’s probably a bigger question of how much higher they’re going to be, and do we really believe in the U.K. going forward as somewhere we want to be placing our money?”

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