Despite the bleak outlook for the UK economy, the London stock market has been one of the best performers in the G7 since early 2022 and is now approaching its record. An opportunity? Not necessarily, because we think the economy will be favourable in 2023, even though the domestic market is struggling. Here are some explanations.
A desperate economy
2022 was a challenging year for the UK. Inflation is among the highest among industrialised economies, averaging 10.4% in the second half of 2022.
Everywhere, the problems of soaring energy prices and other supply difficulties have been accentuated in this market, which has damaged trade links with its leading partner - the European Union – and, at the same time, lost access to the labour force of the Old Continent, since London intended to limit immigration, at all costs.
Faced with this high inflation, the Bank of England had no choice but to raise its key interest rates several times. But here, in a country where credit is widespread, and households are highly indebted, rising prices and rising debt charges have significantly impacted household finances and demand. As a result, the economy began to contract in the third quarter.
Liz Truss' missteps and her willingness to spend recklessly did the rest, upsetting the UK bond market - causing a spike in interest rates that investors were asking for to finance the country - The British Pound has had a very eventful year.
In short, the United Kingdom is struggling - the only G7 economy not to return to its pre-pandemic size - and we see no immediate recovery.
A fairly healthy stock market
In the face of such a flood of bad news, one would expect to see the London stock market struggling.
However, it managed to limit the damage in 2022, doing better than the European stock exchange, the American, Japanese or Chinese. And in the first weeks of 2023, it follows the upward trend elsewhere. Several factors explain this excellent performance.
One is the fact that British equities are trading at a reasonable price. At the end of 2022, they changed over 11 times the price/earnings ratio, compared to 17 times for the World Index (MSCI World).
Then there is the fact that it is a market of the "old economy": consumer staples (20%), finance (17%), energy and health (14% each), raw materials and industry (10% each) make up the bulk of an MSCI UK while, For example, information technology accounts for only 1% of the index.
These are historic, well-established companies, less dependent on credits and new investments than the technologies that have made the success of American market. Moreover, these less fashionable sectors in recent years, such as energy and raw materials, must offer higher returns than others to attract investors' attention.
At a time when inflation is high, and investors are looking for positive yields in real terms, these stocks are regaining some popularity.
Rising interest rates are good news for the financial sector. The increase in commodity and energy prices boosts the profit margins of these sectors but also serves as a justification for the rise in profit margins for primary consumer products, which are present in the London market. Health remains a defensive sector par excellence. However, these FTSE giants are well-positioned to take advantage of this challenging environment.
Finally, it should be recalled that the performance of the British economy does not ultimately matter for the London market. Three-quarters of the profits of the FTSE100 are made abroad, a figure that climbs to more than 90% for AstraZeneca, the first capitalisation of the UK market.
British economy should remain solid
The question is, therefore, whether the excellent performance of the British stock exchange should continue into 2023. And in our opinion, everything leads us to believe this will be the case.
The war in Ukraine will not stop anytime soon, and the West will continue to shift from Russian production of hydrocarbons and other agricultural raw materials. As a result, Europe will have to rebuild its energy stocks without Russia. At the same time, ESG forces and investment in hydrocarbons are limited, and Europe will be increasingly dependent on production elsewhere, thanks to other capital.
In 2022, it benefited from the transition of the Chinese economy, whose growth was at most 3%, to obtain supplies without too much trouble. But China is in full reopening. So while the pandemic will weigh on the Chinese economy in the early weeks of the year, there is little doubt that it will rebound further and that the appetite for energy, mineral and agricultural resources will follow.
The International Energy Agency expects record demand for oil in 2023. And it will probably not be an isolated case: other raw materials may be in high order this year. This suggests continued inflationary pressures and many other problems for our European economies, but also good earnings performance for companies listed in London.
At the same time, the return of inflation to the objectives set by the central banks is not imminent. Since the latter will have great difficulty returning to lower interest rates, financially sound companies that can distribute significant dividends should remain highly prized by investors, especially at an attractive price level.
Finally, London’s recent performance offers another advantage: having evolved quite differently from other stock exchanges in recent years, the London stock exchange also becomes less correlated. That makes it an exciting diversification.
So we continue to buy UK equities in our portfolio.