UK Stock Market: No Recession in Sight, According to Strategist

The biggest risk to the U.K. stock market is avoiding a widely anticipated recession, according to Roger Lee, head of U.K. equity strategy at Investec. Lee believes that the market is underestimating the likelihood of a recession, which could lead to a sharp sell-off.
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The Bank of England has announced that the U.K. has officially entered its longest recession on record. This news comes as a blow to the country, which was already struggling to keep up with the rest of the developed world. Economists expect the U.K.'s economic performance to continue to decline over the next two years.
Lee told CNBC's "Squawk Box Europe" on Wednesday that the biggest risk facing U.K. equities at the moment is that the economy does not enter a recession. He noted that this is the first time in 25 years that he has said this, as the market is currently certain that a recession is coming. However, some economic indicators and company reports suggest that this may not be the case.
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The most important thing to note, according to the Office for National Statistics, is that the U.K. labor market has remained robust. The unemployment rate sat at 3.7% for August to October 2022, while the number of vacancies remains at historically high levels despite five successive quarterly declines.
Since the end of the Second World War, every recession in the United Kingdom or the United States has been accompanied by a significant increase in unemployment. However, we are not seeing that at the moment, according to Lee.
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The FTSE 100 index in Britain has lagged behind most developed market counterparts for many years, especially the S&P 500, as tech and growth stocks have soared.
Many analysts believe that the FTSE 100 index is still undervalued, even after it slightly closed the gap following a disastrous year for Wall Street in 2022. The index now sits only around 2% off its all-time high.
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Lee suggested that the persistent undervaluation of the FTSE, compared to the S&P 500, was due to a combination of U.K. stocks needing to appreciate and U.S. markets having further to fall.
The FTSE is clearly trading at a significant discount not only to global indices but also to its historic average. The FTSE is currently trading at around 10x prospective P/E (price-to-earnings ratio) - its 20-year average is closer to 12.5x P/E, so we don't need anything significant to change particularly," he said.
The price-to-earnings ratio is a tool that investors use to determine whether a company is overvalued or undervalued. The ratio is calculated by dividing a company's current share price by its earnings per share.

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Lee noted that the valuation discount that has built up over the last three years could start to dissipate, potentially leading to a rerating of the FTSE. He clarified that he is not suggesting the FTSE will increase by 25%, but that a rerating is possible.

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The other side of that coin is the risk to the S&P 500 if interest rates stay higher for an extended period of time. That risk has not gone away.
Higher interest rates have a negative impact on growth-oriented stocks, as the value of their future earnings is reduced in today's money. Growth stocks make up a far higher proportion of the US market than in the UK.
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The FTSE is known for its high concentration of consumer staples, financials, industrials and materials companies, and is particularly renowned for the high proportion of firms that pay dividends to shareholders.
Lee contended that the FTSE does get a lot of bad press, but that some of this may be unjustified. He pointed out that if the FTSE paid out its yield in the same way as the MSCI World, the index would be trading well above 9,000 points.
"The FTSE is a big distributor of income, and that clearly costs it index points every single year."