Brexit Britain’s Broken Politics Leave Investors Few Bargains


The British royal family needs impeccable timing and a strong sense of duty, but arranging for a royal baby to arrive around the March 29 date set for Brexit next year is going above and beyond.

Sadly for the government, the announcement of Meghan Markle’s pregnancy—along with a minor royal wedding—hasn’t managed to distract from its troubles at the negotiating table with the European Union. With six months to go, the sides are very far apart, and Britain’s trade-dependent economy is in trouble if there’s no deal.

Despite the crisis, the London stock market is calm, and those looking for bargains will be disappointed. While the U.K. market is a lot cheaper than the S&P 500, the discounts are mostly illusory, and stark threats to British stocks remain.

Start with the politics. Negotiations over Britain’s exit from the E.U. aren’t going well, and that’s just between members of the government. Talks with Brussels haven’t resolved basic questions about the Irish border, let alone moved on to the parties’ future trading relationship after a transition period—the length of which is still undetermined.

Official advice is meanwhile sounding more apocalyptic, with doubts about the supply of medicine, plans to turn a major highway into a parking lot for trucks suffering customs delays and some companies with dealings in Europe being urged to consider shifting out of the U.K.

The concerns show up in options on the pound, which are heavily skewed toward betting on a fall. Over the next year, the standard way to compare deeply out-of-the-money put and call options—known as a 25-delta risk reversal—has tumbled to the levels of negativity it was showing in late 2016, the year of the Brexit referendum (although it went even more negative earlier that year). Investors are paying up to protect themselves against a big drop in sterling.

The U.K. is set to leave the European Union in March 2019. But despite more than two years of negotiations, they still can’t agree on the terms of their separation. The WSJ explains the key sticking points ahead of a set of crucial negotiations. Image: Reuters

Bargain-hunters will be let down looking at stocks, however. True, at 12.3 times estimated earnings over the next 12 months, the FTSE 100 is far cheaper than the S&P 500’s 16.7 times. Yet this isn’t the bargain it looks; the market is as divided by Brexit as the politicians, albeit mostly because of what’s been going on with the pound.

Part of what makes the U.K. look cheap is that, unlike New York’s, London’s market has few of the fast-growing businesses that attract high valuations. Technology has a weight of less than 1% of the FTSE 100, while it is more than a quarter of the S&P. London has much more reliance on lowly valued bank, oil and defensive consumer stocks. Reweight the U.S. market to reflect London’s sectors, using MSCI indexes to maintain a standard approach, and the U.S. valuation drops to 15.8 times earnings.

What accounts for rest of the gap is just that the U.S. is more expensive than other developed markets. London stocks are valued much like stocks in developed countries in the Eurozone (12.6 times earnings), Japan (12.9 times) or the developed world excluding North America (13.1 times).

Performance within the U.K. has been driven by Brexit, because of moves in the pound. London is an unusually international market, with 12 of the FTSE 100 based outside Britain. Many solidly British companies are big foreign earners, too, with close to two-thirds of FTSE 100 revenues from abroad, according to FactSet.

Companies that are exposed to Britain, and so to Brexit, have been terrible performers. The median FTSE 100 stock with three-quarters or more of sales in the U.K. is down 5.4% since the June 2016 referendum—with an extra loss of 11% for dollar-based investors who hadn’t hedged their sterling exposure. By contrast, the median Footsie stock with less than a quarter of its sales in the U.K. rose 36%, before taking the weak pound into account.

If you think you know what will happen with Brexit, your opportunities between now and March 29 are obvious. Believe in a no-deal Brexit? Sell the pound, and buy London’s international stocks. Believe Europe always works like this and a last-minute compromise will emerge? Buy the pound and Britain’s domestic stocks.

There are a few tweaks to all these trades. Good news might help the pound a lot, as FX strategist Kit Juckes at Société Générale points out, because there’s already such a skew against it in options. Equally, bad news would have to be really bad to hurt.

Individual stocks can of course buck the Brexit trend. There are highly international stocks, such as Mexican gold-miner Fresnillo, that have fallen, and domestic stocks, such as online grocer Ocado, that have soared.

In the long run, the trade barriers that Brexit brings will depress growth and weaken the outlook for domestic companies. But the true threat to investors comes from Britain’s broken politics. Voters are now willing to accept ideas they would have dismissed as unworkable just a few years ago, and both main parties have rejected the old consensus of international capitalism on which London’s market was built.

It’ll take a lot more than a royal infant, however cute, to stop investors thinking about that.

Write to James Mackintosh at James.Mackintosh@wsj.com



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