U.K. Might Look Cheap, but It’s Hardly a Bargain Yet
It was a strange way to launch a new monarchy and a new government.
The immediate antecedents to the multiple crises now gripping the United Kingdom go back years—to the 2008-09 financial crisis, the weakening of the pound sterling, austerity budgets, Brexit, the pandemic, and the fall of Boris Johnson.
So, it was never going to be easy for a new Tory government led by Prime Minister Liz Truss. But her decision to provide a massive subsidy to help consumers pay for spiking energy costs, and then to offer the largest tax cuts since 1972, threatened to drive inflation higher and resulted in the pound plunging, government debt yields rising, and the Bank of England intervening in the bond markets to save a pension system stuffed with gilts.
And those are just the immediate economic problems. The Truss government also faces restiveness in Scotland and Northern Ireland, tough negotiations on trade with the European Union, chronic productivity shortcomings, and decades of economic stagnation. Not to mention the war in Ukraine and an energy crisis.
Which raises the question: Is it time to buy U.K. yet?
The answer isn’t an easy one. Investible assets, from blue-chip companies to prime real estate, have grown relatively cheaper in the U.K., particularly if you’re paying in dollars, which have strengthened as the pound has weakened. Blackstone BX –0.90% (ticker: BX) CEO Steve Schwarzman recently paid $85.5 million for a 2,500-acre historic property in Wiltshire. As Bloomberg noted, the property would have cost $110 million last year, purely on a currency-exchange basis.
Jefferies global equity strategist Sean Darby thinks many U.K. companies are healthy, and a weaker pound makes them likelier to attract attention as investments or acquisition targets.
In fact, some U.K. stocks, many of which have large international interests, have held up despite the turmoil. The best performer on the blue-chip FTSE 100UKX +0.18% index this year has been defense contractor BAE Systems BA –4.27% (BA.UK), up about 44% in local terms. Not surprisingly, Shell SHEL +0.22% (SHEL.UK) and BP BP +0.24% (BP.UK) have benefited from higher energy costs. They dodged a bullet when Truss ruled out a windfall profits tax on energy companies.
The FTSE 100 is down 6.65% this year in local currency and 23% in dollar terms. The only time in the past 20 years that the iShares MSCI United Kingdom exchange-traded fund’s (EWU) price/earnings ratio—8.5—was lower on a monthly basis was during the financial crisis of 2008-09.
“Sterling and many British corporate assets may now be cheap enough to discount all but the most catastrophic outcomes,” wrote Anatole Kaletsky, an analyst at Gavekal, in a note. “Modest speculative investments on British assets may therefore be worthwhile.”
But the recent moves by the government threaten to worsen an already fragile fiscal and macroeconomic situation. Contradictory forces have been unleashed, making uncertainties greater. The government plans a strongly inflationary program but hasn’t said how it would be funded, and initially resisted an independent cost analysis by the Office of Budget Responsibility. On Friday, Truss and Chancellor of the Exchequer Kwasi Kwarteng met with the head of the OBR, which will conduct the analysis.
Meanwhile, to deal with inflation, the Bank of England will have to raise interest rates, a contractionary policy that might crash a housing market ultrasensitive to mortgage rates, and send the rest of the economy spiraling down. And a rare rate hike between BOE policy meetings might spook the markets or leave them wanting more.
“We’d caution against fighting fire with fire,” says Nomura economist George Buckley. “Raising rates by more than is warranted by the inflation outlook to deal with higher market yields and lower sterling is likely to backfire.”
This is not a pretty picture. “The U.K. had an excellent reputation, and it’s in danger of losing that extremely quickly,” says Campbell Leith, professor of macroeconomics at the University of Glasgow. “It’s unprecedented.”
Of course, the government could backtrack on tax cuts, but that might be political suicide for Truss, after having campaigned for the prime minister’s job on promises to ditch economic orthodoxy and seek radical solutions. Despite being scolded by everyone from the International Monetary Fund to former U.S. Treasury Secretary Lawrence Summers, Truss will hold fast, early signs indicate. She insists that she’s making difficult decisions to strengthen growth.
If Truss does stick to her guns, she and Kwarteng may be able to placate markets by announcing fiscal rules for the years ahead, says Nomura’s Buckley. This would mean detailing how the government will pay for tax cuts and how it will reduce debt in the long term. But Truss might find it difficult to push through more reforms. Not only would she risk another market backlash, but also she could face opposition from her own MPs, worried about their chances for re-election if the economy melts down. One poll last week showed Labour with a 33% favorability lead over the Tories.
The least likely scenario is a currency intervention to prop up the pound, which has dipped to a record low of $1.03; it was $2 in 2007. Duncan Weldon, an economist and the author of the book Two Hundred Years of Muddling Through, an economic history of Britain, says that the U.K. not only lacks the reserves to get far with such an effort, but also the experience of being forced to withdraw from the European Exchange Rate Mechanism in 1992—the last time the government tried to boost the currency with purchases—has left scars.
That was the notorious Black Wednesday, when currency traders, including George Soros, made billions by shorting sterling at the government’s expense. Ironically, getting booted from the ERM ultimately helped the U.K. economy, which went on to experience 16 years of economic expansion that ended only in 2008.
The standoff can end in only one of two ways, says Leith. The first is that the government convinces markets that Truss’ policies are sustainable. While she’s politically unable to backtrack, she might opt to raise other taxes to cover shortfalls and reduce the need for more borrowing. That might ease the need for more BOE rate rises. The second is that the BOE allows inflation to run hot, sacrificing its independence. “If the Bank of England helps out by softening monetary policy, then that’s going to be painful,” he says. “That’s not the best way of resolving this, but it would resolve it.”
In an interview with Barron’s this past week, Raghuram Rajan, a finance professor at the University of Chicago and former head of the Reserve Bank of India, noted the buildup of stresses in institutions and politics of countries like the U.K. “The differences between industrialized and emerging markets was that politics was much worse in emerging markets, with more conflicts and less consensus on direction,” he said. “Now we have industrial countries that have more conflicts of policy direction.”
Stephen Cucchiaro, CEO and chief investment officer of 3EDGE Asset Management, a global investment firm based in Boston, thinks it’s too early to get in. “At some point, we expect the U.K. market to outperform the U.S.,” based on the former’s low valuation. “We’d first want to see a sustainable recovery in the bond and currency markets.”