Fortunes Diverge for U.K. and Its Stocks

By Tommy Stubbington 

The U.K. economy is picking up, but the country's stock market isn't.

Amid all of Europe's struggles in 2014, the region's worst-performing major market index is London's flagship FTSE 100, which has fallen 3%. Even Italy, whose economy is set to contract in 2014 for the third year running, has mustered a small gain.

And investors in the U.K. see few reasons for optimism in 2015. The FTSE is filled with oil producers, miners and others slumping in the commodities rout. The Bank of England looks set to tighten monetary policy. And an unpredictable general election looms in the spring.

Britain's underperformance is notable given its relative strength: Its economy is expected to grow faster this year than any of the 18 eurozone countries except Ireland, according to the European Commission's most recent forecast. Yet the FTSE's 3% decline compares with a 4% gain in the pan-European Stoxx Europe 600 excluding U.K. shares. The comparison with the U.S. is even less flattering: The S&P 500 is up 13% this year as of Tuesday afternoon. Even Russia, gripped by punishing sanctions and a financial crisis, is faring only somewhat worse. The Micex index, which is priced in rubles, is down 7%. (In dollar terms, Russian markets have fallen spectacularly alongside the plummeting ruble.)

Energy companies--a hefty presence on London markets--have found themselves in the firing line following a collapse in oil prices since the summer. Tullow Oil PLC and BG Group PLC are among the worst performers on the FTSE, while giant BP PLC has also stumbled. That is likely to continue to weigh on the market as the effect of cheaper oil feeds through to company profits, investors say.

"Earnings in the energy sector had shown signs of stabilization in recent months, but the decline in oil prices in the second half of this year means earnings are likely to take a leg down," said Mark Haefele, global chief investment officer at UBS Wealth Management, which oversees around $2 trillion of assets.

But there have also been pockets of weakness in sectors that would typically benefit from an economic recovery, such as food retail. Grocery chains Tesco PLC, J Sainsbury PLC and Wm. Morrison Supermarkets PLC have all fallen by 30% or more. An accounting scandal at Tesco has been compounded by a price war as cost-cutting rivals nab market share from the established chains and low inflation hampers retailers' ability to raise prices.

"Increased competition in the food retail sector is a good thing for growth but bad from shareholders' perspective. That doesn't look like it's about to change," said Guy Foster, head of portfolio strategy at wealth manager Brewin Dolphin, which oversees GBP29.4 billion ($45.6 billion) of assets.

Brewin Dolphin favors U.S., eurozone and Japanese markets over U.K. stocks in its portfolios, Mr. Foster said, even though the latter look relatively cheap.

The FTSE 100 currently trades on a forward price-to-earnings ratio--a measure of how much investors are prepared to pay for each pound of expected profit next year--of 13.89, according to FactSet. That compares with 16.13 for the Stoxx Europe 600 excluding the U.K.

Many other investors are similarly downbeat.

A survey of more than 100 money managers carried out this month by Bank of America Merrill Lynch showed that a net 16% are underweight U.K. stocks. "The U.K. remains the least favored region globally," the bank said.

Mr. Haefele at UBS Wealth also worries that a thriving economy could actually hurt shares. The British economy expanded at a rate of 2.6% in the three months to September, compared with a year earlier, while the eurozone barely eked out any growth at all. For much of 2014, the strengthening economy prompted bets that the Bank of England would raise interest rates in the coming year. Those expectations have been pushed back recently amid a slowing of the pace of inflation across the globe, but investors still think the BOE will be one of the first major central banks to increase rates. Such a move would boost the U.K. pound--bad news for the FTSE 100's exporters and multinationals, which earn more than 75% of their revenue overseas.

The prospect of stronger sterling against the euro is one reason why UBS Wealth this month further cut its holdings of U.K. stocks, having already been underweight, Mr. Haefele said.

This dim view reverses the situation of the previous few years, when shares remained buoyant despite a struggling economy. During the financial crisis, ultraloose BOE policy weakened sterling and drew investors to the relative safe haven of U.K. government debt. Lower bond yields meant equity markets looked more attractive by comparison.

"People used to ask why the stock market is doing so well when we're having a triple-dip recession. Now the question has been turned on its head," said Mr. Foster of Brewin Dolphin.

An unpredictable general election in May also presents a challenge for investors. Current polls indicate that traditional major parties will struggle to cement an overall majority, increasing the likelihood of a place in government for the separatistScottish Nationalist Party, or the United Kingdom Independence Party, which advocates a British departure from the European Union.

That is a prospect that markets are currently ignoring, but are likely to react to next year, said Frederic Dodard, head of investment solutions at State Street Global Advisors, which manages $2.38 trillion. State Street prefers U.S. stocks to European, with political uncertainty in the U.K. and the eurozone partly responsible for the caution, according to Mr. Dodard.

"A higher level of uncertainty is never good for risk assets," he said.

Write to Tommy Stubbington at [e-mail]

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