Morgan Stanley: Getting More Out Of The UK Economy Won't Be A Quick Fix

By Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley

Labour at Dawn

Elections in the United Kingdom have delivered the first change in government in 14 years and the second-largest majority for any party since 1945. It's a big change in a country whose markets trade at a historically large discount.

The incoming Labour government will inherit a UK economy that, by many measures, has underperformed sharply. Since 2010, the UK has grown ~10% less than the US while experiencing higher inflation. The 2016 decision to leave the European Union has put barriers between the UK and its largest trading partners; over the long run imports and exports are likely to be 15% lower than if the UK has remained in the EU per the OBR. Since Covid, the UK has seen the second-slowest economic recovery in the G7. The lack of long-term fixed-rate mortgages (so common in the US) means that higher rates have hit the consumer hard.

UK markets have suffered from a similar malaise. Since 2010, global equities (MSCI World) have gained 284%, including dividends. The same figure for UK equities is just 94%, underperforming to the tune of 5.2% per year. And this malaise has been remarkably consistent: In the 14 calendar years since 2010, the UK stock market has beaten global stock markets only once…in 2022, a year when it still fell by 5%.

The UK equity market is not the economy (only 25% of the revenue of MSCI UK comes from the UK). And yet, from afar, it seems to be suffering from similar strains of being left behind. Brexit suggested an inward turn in an increasingly global world, while the country’s technology sector lagged. Information Technology is about ~1% of the FTSE 100, for example. It is 33% of the S&P 500.

Weak growth and weak returns have led many global investors to look away from the UK. Persistent weakness has rewarded them for it.

But a new government might, and we’d stress might, change that. In a world where politics feels increasingly fractured and unstable, the new Labour government has a five-year term and a substantial majority. In a world where most investors we speak with seem resigned to the idea that the rise of populism means fiscal policy can only ratchet looser, that is not what the new government has proposed.

Meanwhile, the UK economy does have potential. It benefits from an educated workforce, strength in scientific research and an extremely competitive global services sector in everything from entertainment to law to finance. Our chief UK economist, Bruna Skarica, continues to expect the Bank of England to make its first rate cut in August, easing some pressure on consumers.

But getting more out of the UK economy won’t be a quick fix. Instead, the more immediate factor that may lead global investors to take another look at the UK is price. The long-run malaise means that the FTSE 100 now trades at 12.1x P/E and 3.9% yield. This represents its largest-ever P/E discount to MSCI World (37%) and more than the double its average discount to equities in Europe. The valuations of the smaller-cap FTSE 250 are even more depressed. My colleague Marina Zavolock and our European equity strategy team are bullish on the UK as they are on the wider MSCI Europe. My colleague Wanting Low in FX strategy sees GBP/EUR moving higher.

It's a similar story in real estate – the malaise is the opportunity. My colleague Bart Gysens notes that continental European commercial real estate values soared over the last decade, spurring more borrowing against these higher valuations. But Brexit and the resulting uncertainty created a very different dynamic in the UK, leading to better balance sheets and higher cap rates. He and his team are OW a number of UK property names.

Credit is notable as one area where the UK discount isn’t as pronounced; GBP credit spreads are actually a little tighter on the 10-year range than the EUR market, and similar to what we see in USD credit. Here, we expect the impact of a new government to be more idiosyncratic, especially around the water and electricity sectors. And yielding ~5.5%, total returns for GBP credit look attractive.

It's the dawn of a new government in the UK with a substantial majority. It may, and we stress may, offer a notable alignment: A country in need of investment and short of domestic savings, with a global investor base eager to find political stability and reasonable valuations in the current environment. Time will tell.