The UK stock market looks cheap. The two most obvious explanations for their cheapness are Brexit and Corbyn. That raises the question: are markets worrying too much?
Or, to put it another way, have UK share prices fallen too far?
Before we answer that, let's take a quick look at valuation. My favourite measure when I'm comparing regional stock markets is the CAPE ratio (cyclically adjusted price/earnings ratio). It compares share prices with profits over the last decade and so shouldn't be affected by cyclical issues.
Here are recent CAPE ratios for four leading markets. The UK is clearly the cheapest.
Cape ratios
CountryCAPE ratioUK17.8Germany19.8Japan25.2US29.4
Date: 30/10/18 Source: Barclays
The UK market has fallen since these ratios were calculated at the end of October, so the UK's ratio should be well below 17 now. In other words, it's even cheaper.
So should you take the plunge and buy the seemingly cheap UK market?
Brexit
Clearly the outcome of Brexit is very important here. I'm in no doubt that the UK market has already priced in a fair bit of Brexit bad news. But there's a lot of uncertainty.
This quote from Citi's global outlook research for 2019 sums it up: "Brexit uncertainty is too high at this point confidently to forecast anything for the UK in the short, medium or long term."
That said, if we leave the EU in an orderly fashion at the end of March, we'll probably see a Brexit share price bounce. Equally, if we have a 'no-deal' Brexit, further share price falls seem likely. (But even then, there's a judgement call here - you have to decide whether a no-deal Brexit will seriously disrupt our economy or not.) And I'm not even going to try and predict what might happen if Brexit was delayed or cancelled.
Citi did put its neck on the line and say that a no-deal Brexit would take 5% off UK GDP over the next three years. That's a fair old whack, and it would definitely mean a recession, but it's not Armageddon either. But it's all guess work, and, in the end, I suspect that it's the uncertainty that has kept many investors out of the UK market so far.
That uncertainty is heightened by the possibility of a Labour government led by Jeremy Corbyn.
But that uncertainty and nervousness means many investors are missing out on some big global companies that happen to be listed in the UK, and are often headquartered here too. These companies make most of their profits away from the UK and shouldn't be greatly damaged by Brexit. Examples include Unilever, Diageo, GSK, and BP.
And then you have businesses that are predominantly UK-focused which have been hit even harder. You'll find some of these companies in the FTSE 250 although don't fall into the trap of thinking all companies in the FTSE 250 are UK-focused.
One especially hard hit sector is housebuilders. Shares in one of the larger builders, Persimmon, are down about a third this year and are trading on a price/earnings ratio of less than seven. The dividend yield is over 12%! (Such a high yield suggests the dividend is not secure.) The company also have over a billion pounds of net cash on its balance sheet.
As Oliver Smith, portfolio manager at IG Markets, points in our latest Big Call Radio Show, housebuilder share prices have also been very volatile in recent weeks. There have been days where we've seen share price movements of as much as 10% as optimism about Brexit rises or falls.
That said, Smith doesn't think investors should see Brexit as an opportunity for a short-term trade on the Brexit outcome.
"The problem with essentially making a short term trade is that there's a binary outcome of you either being right or wrong…when you look at the long term driver of company share price growth, it isn't going to be what happens to the UK economy in the next six months. It's going to be what happens in the next six years. So as long as you have an internationally diversified portfolio, this really is short-term noise that the majority of people can look through, as uncomfortable as that may seem in the short term."
Rate rises
Of course, Brexit and Corbyn won't be the only drivers of UK share prices in 2019. A theme for global markets this year has been monetary policy. Interest rates have started to rise in many countries and we're likely to see more quantitative tightening as central banks gradually start to reduce the bond holdings they built up in the aftermath of the financial crisis.
Citi reckons that rising wage growth and low unemployment means that the Bank of England will be keen to raise rates next year. The bank thinks the most likely scenario is a 25 basis point (0.25%) rise in both May and November, followed by further rises every six months after that. All other things being equal, rising rates should boost the pound and that could limit gains for the FTSE 100 and wider UK market. (Of course, if Brexit does prove to be tumultuous, Mark Carney might hold off from any rate rises at all.)
Rising rates might boost the pound which could be bad news for many FTSE 100 shares - big global businesses are able to convert their overseas profits into higher sterling-denominated earnings when the pound is low.
Entry point
Here's another gloomy piece of guesswork. Nigel Bolton, a highly respected fund manager at Blackrock, thinks a no-deal Brexit could take as much as 30% off UK-focused stocks. He may well be right. But most of the shares will probably recover eventually. And in my mind, I keep coming back to the point that so many FTSE 100 companies are global businesses, and that makes the Footsie a pretty tempting index to me.
Perhaps the best approach is to say that now is a good entry point for a long-term investment in the UK market. Don't put all your money into the UK - you should definitely diversify - but the general principle of buying shares when they're cheap and holding them for the long term remains sound.
What next?
If you want to invest in the UK using ETFs, check out Five top UK ETFs which highlights ETFs that track different parts of the UK market. You can also get more background in Investing in UK Large Caps.
