Picture: PUBLIC DOMAIN IMAGE
Picture: PUBLIC DOMAIN IMAGE

London — For those with the stomach to digest more months of Brexit-induced political wrangling, sterling’s plunge to two-year lows is raising the question — is it time to dip back into hard-hit British markets for potential bargains?

The pound has shed more than 8% since May, a drop that has accelerated since Prime Minister Boris Johnson declared the UK would leave the EU on October 31, with or without a transitional trade agreement.

A no-deal exit could inflict huge damage on the UK economy.

Bank of England(BOE) governor Mark Carney repeated that warning this week, and the prospect has driven significant underperformance in UK equities and real estate, and saddled British UK companies looking to borrow overseas with a “Brexit premium”.

Investors are generally staying clear of big bets on a UK recovery, and few are brave enough to predict when the political turmoil might end. The rest of the year could easily bring snap national elections, another Brexit delay and more uncertainty.

After sterling’s latest lurch lower, however, some managers with long horizons are taking a second look and concluding that — at least on paper — some British assets look too cheap to ignore. Also tempting is the prospect of a sterling rally if a no-deal Brexit is averted. Reuters polls show it could bounce to $1.36.

“We’re having those discussions internally, because domestic UK assets are starting to look quite cheap relative to elsewhere,” said Legal & General Investment Management’s head of economics Tim Drayson. “Everyone’s joking it’s a brave decision to do it ... As is always the case, if the disconnect continues to widen, it will be worth the risk.”

A weaker pound makes it cheaper for overseas investors holding other currencies to buy British assets. It can also provide UK-based fund managers with an incentive to take profits on foreign holdings and repatriate the cash.

Cheap valuations aside, there is a belief in some quarters that the UK economy should be able to weather Brexit as long as a no-deal is averted. Positives include low unemployment, resilient consumer spending and Johnson’s promise of more investment.

Some fund managers have already started buying. Martin Todd at Hermes Investment Management said he had “marginally increased UK equity exposure thanks to better-looking valuations”.

How cheap?

So how cheap is the pound really? On JPMorgan’s real effective exchange rate index, which measures currencies’ inflation-adjusted value against trading partners, the pound is cheaper than at any time since October 2016.

Trading at around $1.50 before the 2016 Brexit referendum, sterling has stumbled to less than $1.21. Parity with the dollar and the euro could beckon under a no-deal scenario. But UBS Wealth Management sees sterling as “increasingly oversold” against the dollar. The pound’s purchasing power parity (PPP) valuation is $1.57, it told clients — 30% above current levels.

Also on the slide are UK equities and British commercial and residential real estate, long a magnet for overseas buyers

That measure takes into account what money can buy in two different currencies, and many investors believe currencies gravitate towards it. “We are not expecting a sharp convergence to PPP anytime soon, but this highlights the extent of sterling undervaluation and the scope of a recovery,” UBS Wealth said.

Of course, not everyone is piling back in. A currency trader at a major bank said clients were wary of buying sterling until it was firmly below $1.20.

The debate for many is whether sterling reverts to historical averages once the dust settles or if Brexit does permanent damage to its long-term fair value.

For fans of “mean reversion”, the pound is near the bottom of a 35-year trading range between $1.0 and $2.0. What’s more, it’s only spent 0.7% of the time since 1985 below $1.20.

Others think old charts might need to be ripped up. “It is not unreasonable to conclude that a no-deal Brexit outcome would result in a structural revaluation of sterling,” said Roger Hallam, currency chief investment officer at JP Morgan Asset Management.

Stocks and property

Also on the slide are UK equities and British commercial and residential real estate, long a magnet for overseas buyers.

JPMorgan’s index of British domestic-focused stocks , including supermarket J Sainsbury and insurer Admiral, has fallen 12% since April.

Since the 2016 referendum, the domestically focused FTSE 250 index has fallen in euro terms by 2%, even though earnings growth has held up relatively well. The S&P 500 has surged 112% in euro terms over the same period.

Price-to-earnings multiples for FTSE 250 stocks also stand below their eurozone and US equivalents.

Since June 2016, UK property stocks are down 28% in dollar terms while global property shares have risen 15%. London house prices fell at their fastest pace in almost 10 years in May, while investment in commercial property has fallen.

“We do see good relative value in UK real estate right now, despite elevated political risk,” said Simon Durkin, BlackRock’s head of European real assets research.

Julian Sandbach, head of central London capital markets at Jones Lang LaSalle, said that in recent weeks, long-term focused Asian investors had returned to the London office market, and the pound’s plunge was the catalyst.

“Whatever happens, the longer-term prospects are extremely good for the UK,” said a person familiar with sovereign wealth fund (SWF) investment in Britain — adding that most SWFs were likely to hold off until “a further sterling fall and clarity on the terms of the [EU] exit”.

Reuters