UK stocks look cheap, but the real picture is complicated

Small and medium stocks are not hugely underpriced, while the direction of Brexit talks will have a big impact.

A dispiriting performance by an unloved FTSE 100 index in recent months has left the UK's valuation against global and European peers at its lowest level in nearly 40 years.

The near-record underperformance, highlighted today in a note by Morgan Stanley, reflects not just Brexit uncertainty deterring international investors but the fact that the UK has one of the lowest tech stock weightings across the largest 15 markets worldwide.

This means that while the FTSE 100 has been range-bound all summer at levels either side of 6,000, the momentum offered by the likes of Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN) and Tesla (NASDAQ:TSLA) has helped Wall Street markets to recover all their initial Covid-19 losses before going on to set record highs.

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The UK is clearly looking cheap, but Morgan Stanley warns investors that things remain complicated beneath the surface. In particular, equity valuations do not look especially depressed at the small and mid-cap level, which in itself highlights that much of the problem with the UK at the moment is due to the sector mix of larger caps.

A Brexit deal later this year should increase investor interest in the UK, but it's more likely to be domestically exposed stocks and the FTSE 250 index that benefit the most.

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Sterling strength resulting from any trade deal with the EU would be a headwind for the FTSE 100 index, a factor highlighted in reverse on Monday when a weaker pound triggered gains for dollar-earning stocks and helped the top flight to power 2.7% higher.

Morgan Stanley's FX strategists see the pound rising to 1.40 against the US dollar in the event of a Brexit deal and to 1.20 if the UK settles for World Trade Organisation terms.

The bank added: “If there is a Brexit deal this autumn, as our economists anticipate, we'd expect the FTSE 250 to re-rate further towards the 20-25% price/earnings premium levels seen earlier in the last decade.”

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Looking across Europe, the bank notes that we have transitioned from a late-cycle economy to an early-cycle one over the course of this year. “Consequently, we see strong GDP (gross domestic product) and EPS (earnings per share) growth ahead, which is only partially in the price for stocks.”

That's helped a number of value stocks in recent months, with some still looking attractive despite this outperformance. Overweight stocks include British American Tobacco (LSE:BATS), according to today's note.

Its economists also expect US inflation to surprise on the upside, which traditionally favours commodities, cyclicals and financials.

These inflation dynamics should boost value stocks for the rest of the year, as would any positive news on a coronavirus vaccine. Progress on a jab is likely to encourage rotation into more cyclical areas, which along with US election risk is why Morgan Stanley has downgraded the pharmaceuticals sector to underweight.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.