The UK Is In A Tough Spot. Can You Make It Work For Your Portfolio?

The UK Is In A Tough Spot. Can You Make It Work For Your Portfolio?
Russell Burns

over 1 year ago4 mins

  • The economic crisis and high inflation in the UK are beginning to reduce confidence in its currency and bond markets.

  • The FTSE 100 has performed well as many of its members have a large proportion of their sales outside the UK, but the outlook for small and mid-cap domestic-focused companies remains poor.

  • Shell looks cheap, while consumer discretionary names could bounce further as support from the package suggests the worst could be over for now.

The economic crisis and high inflation in the UK are beginning to reduce confidence in its currency and bond markets.

The FTSE 100 has performed well as many of its members have a large proportion of their sales outside the UK, but the outlook for small and mid-cap domestic-focused companies remains poor.

Shell looks cheap, while consumer discretionary names could bounce further as support from the package suggests the worst could be over for now.

Mentioned in story

It seems like no one’s very happy to “keep calm and carry on” investing in the UK these days. With the country facing high inflation, a debilitating energy crisis, a slide in economic growth, and now a change in leadership, investors have been dumping the UK’s currency and its bonds. But with every crisis, there are opportunities for you to make money. And this one’s no different…

Why are investors worried about the UK?

With everything the UK economy is facing, the next year isn’t likely to be an easy one. So investors have been skeptical about a £100 billion ($115 billion) plan, floated by its new prime minister, Liz Truss, to steer the economy through the economic crisis. They know higher government spending tends to lead to higher inflation – and that’s something the UK could really do without. Inflation is already above 10% and hurting the country’s economy. And with Russia’s war in Ukraine driving further increases in food and fuel prices, inflation is expected to only increase this winter. A big government spending package, then, could drive prices even higher – possibly as high as 22% next year, according to investment bank Goldman Sachs.

Economists now generally agree that the UK is headed for stagflation, a dismal, prolonged period of slow or negative growth and high inflation. And while none of it is pretty, all of it appears to be coming to a head in the markets. In August, the UK’s government 10-year bonds saw their largest rise in yields since the late 1980s. And the British pound fell sharply too – dropping 4.5% against the US dollar, the worst performance among the big “G10” industrialized economy currencies.

August Performance of GBP and the UK government bond index. Source: Bloomberg
August Performance of GBP and the UK government bond index. Source: Bloomberg

The weaker pound does make matters worse: the UK runs a “current account deficit” – meaning it imports more stuff than it exports – and a weaker currency makes its imports more expensive, which just fuels even more inflation, and may serve to drive the currency even lower, and the trade deficit higher. In a worst-case scenario, it could even plunge the pound down another 30%, Deutsche Bank said this week.

So what’s the opportunity then?

There’s an old market adage that says bond traders are smarter than equity traders. And of course, not everyone agrees with that, but the point is: when they have a strong change in opinion, that’s when you want to pay attention. And that huge selloff in August in both the British pound and UK government bonds may have been one of those moments.

If you think bond traders might be onto something in their view of the UK, you could consider these four moves for your portfolio:

1. Shorting the British pound. Investors are increasingly betting that the pound will trade at parity – or 1-for-1 – with the US dollar, possibly as soon as next year. So you could consider “going short” (or selling) the pound and “going long” (or buying) the greenback, a move you can make using margin via your broker. You could also consider buying the WisdomTree Long USD Short GBP ETF (ticker: GBUS, expense ratio: 0.39%).

2. Going long FTSE 100 vs Short FTSE 250. The UK economy is under pressure, but the large-cap-focused FTSE 100 is actually one of the best-performing indexes so far this year. That’s because many of its companies have large overseas operations and revenues in US dollars, so a weak British pound actually helps their earnings. Meanwhile, the mid-sized-focused FTSE250, whose companies are more exposed to the UK economy, has (unsurprisingly) struggled. If you see this trend continuing, you could consider buying the Vanguard FTSE 100 ETF (VUKE, 0.09%), and shorting the Vanguard FTSE 250 ETF (VMID, 0.10%).

3. Buying shares of Shell. If you want exposure to oil and gas, Shell (SHEL LN), the largest company in the FTSE 100, looks cheap: it’s trading at a 5x price-to-earnings (PE) ratio, compared to the index’s average 9x price-to-earnings ratio. Although its dividend yield is only 3.5%, the company does reward shareholders with share buybacks. Strong earnings and free cash flow generation make an increase to its current £6 billion ($7 billion) buyback likely. Shell also has a US listing, priced in US dollars (SHEL US).

4. Buying shares in consumer discretionary companies: This one might seem counterintuitive. But bear with. Consumer discretionary spending is, of course, what comes after paying for essential, “need-to-have” things like heating, rent, and groceries. Restaurants and bakeries fall in that “nice-to-have” discretionary spending category, for example. Plus, bakeries and pizzerias have to use their ovens – think gas and electricity – for large parts of the day. Not surprising, then, that their share prices had been falling as a result of the energy and cost of living crisis. But on Tuesday, that started to shift as details of a new stimulus package began to emerge. It’s set to include support for businesses and households – suggesting that the worst may be over for the consumer discretionary sector. You could consider buying shares in Restaurant Group (RTN LN) or bakery chain Greggs, (GRG LN), or Domino’s Pizza (DOM LN), the UK franchise of US-based Domino’s Pizza.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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