The British Economy Looks Ugly. Investors, Now’s the Time to Strike.

That doom and gloom has been reflected in the performance of the FTSE 100 index this year. While the S&P 500 has gained 17%, Japan’s Nikkei is up 24%, Germany’s DAX is up 16%. The FTSE 100, by contrast, has been flat.

The good news is that this is an opportunity for savvy investors, for two reasons. One, FTSE 100 companies make 80% of their earnings outside of the U.K.–they’re not reliant on the domestic economy. And two, valuations of U.K. companies are trading at about a 20% discount to global peers, according to Charles Luke, an investment manager at
Murray Income Trust.
That gives them scope to catch up.

The U.K. market “is cheap in absolute terms, relative to history and also relative to global equities,” Luke said in a June 28 report. “Investors are getting global income at a knockdown price.”

The sector composition of the U.K. could make it a good play for the second half of the year, said Hugh Gimber, global market strategist at
J.P. Morgan
Asset Management in London.

Whereas U.S. markets have been driven higher by technology stocks, the FTSE has more financial companies, which stand to benefit from higher interest rates. 

While inflation remains stubbornly high in the U.K., it should start to come down quickly now, much as it already has in the U.S. and other countries largely due to energy prices staying lower than they were a year ago. The headline rate fell more than expected in June to a 15-month low of 7.9%.

That could bode well for consumer staple stocks, such as drinks maker
Diageo
(ticker: DGE) or goods maker
Unilever
(ULVR).
Diageo,
with a market capitalization of about $100 billion, has fallen 6% this year, and most analysts give them a Buy rating with an average 11% upside in the target price. Its price-earnings ratio is in line with peers. At its last half-year earnings in January, it reported slowing growth in North America, where it sells Don Julio and Casamigos tequila.
Unilever
is down 2.6% since Jan. 1 and has an 8.2% implied upside in the average target price.

Falling inflation could also boost travel-related stocks such as British Airways owner
International Consolidated Airlines
(IAG), which has already gained 27% this year. That’s still less than the share-price gains of more than 45% at U.S. rivals
American Airlines
(AAL) and
United
(UAL).

Energy giants
Shell
(SHEL) and
BP
(BP) have been performing very similarly to peers, but their shares still trade at a significant discount. BP trades at 6.4 times forward earnings,
Shell
is at 7.5 times.
Exxon,
the biggest U.S. oil producer, is trading at 11 times earnings by comparison.

BP stock has dropped more than 15% since February. Like its peers, it has been hurt by falling oil prices this year, but at its last earnings in May it beat analyst estimates for profitability. With a market capitalization of about $105 billion, the company promised to be disciplined with investments, lower debt and increase distributions to shareholders.

The U.K. got into its current predicament through bad luck and some bad choices. A tight labor market is keeping the pressure on inflation, much as it is in the U.S. And the U.K. was also very exposed to the jump in natural-gas prices after Russia invaded Ukraine, like the rest of Europe. It was a double whammy that caught the Bank of England off guard, even though the U.K. central bank started raising interest rates months before the Fed. 

On top of that, the U.K.’s messy separation from the European Union is dragging on economic growth and gumming up supply chains. And a short-lived attempt to open up the supply side of the economy with large tax cuts last autumn under the two-month tenure of Prime Minister Liz Truss spooked the bond market, pushing yields up. Confidence in the government may have recovered somewhat since, but persistent battles over pay for nurses, teachers and train drivers still weigh on sentiment.

Even though prospects for growth are dim, the outlook for stocks is brighter. 

“The U.K. economic outlook is more challenging than other parts of the world,” J.P. Morgan’s Gimber said. “But the equity market could actually stand to benefit.”

Write to Brian Swint at [email protected]