Barron’s: Brexit is far from the only worry for U.K. stocks

The United Kingdom has endured more turbulence this month, with Prime Minister Theresa May looking in danger of losing her job and Brexit talks reaching a stalemate.

Such political problems add to the case for dialing back on broad bets on British stocks. But the biggest reason to underweight them could be the U.K. market’s makeup.

Central banks world-wide have been signaling an end to the era of ultra-easy money. That’s a challenge for the London market, which is heavy on dividend payers and defensive plays, says Mislav Matejka, JPMorgan’s U.K.-based head of global and European equity strategy.

“If the story is that the central banks are tapering or tightening—and bond yields should be bottoming out and rising—then the U.K. is simply not the place you want to be,” he says.

Another difficulty: The U.S. dollar looks to have found a bottom after falling against rival currencies for most of this year, and that could weigh on commodity prices and the many commodity producers in the U.K.’s FTSE 100 benchmark, says Matejka. A strengthening buck can hold back commodities that trade in dollars because it makes them pricier for holders of other currencies.

Matejka and his team are recommending that investors underweight U.K. stocks. They have a year-end target of 7500 for the FTSE 100, implying that the benchmark essentially will shuffle sideways for the rest of 2017.

The J.P. Morgan strategists are hardly perma-bears on British stocks, though. They advised overweighting U.K. equities through the Brexit referendum in June 2016, predicting that the pound would tumble on a vote to leave, boosting the FTSE. (A weaker pound can help the index because many of its multinational components generate most of their revenue in other currencies.)

That call proved to be a good one. But the bank’s team went on to decide that the consensus view had become overly complacent, and they have kept their rating on U.K. stocks at either underweight or neutral for about a year.

The FTSE 100

UKX, +0.62%

has gained about 8% over the past 12 months, scoring a record close during the past week. The Stoxx Europe 600

SXXP, +0.29%

 index has advanced 15% over that period, and the S&P 500 index

SPX, +0.09%

 is up 19%. “We think this underperformance will continue,” Matejka says, but adds that “we’re not saying necessarily that equities in the U.K. will go down.”

Political uncertainty is also a headache for U.K. stocks, albeit not the No. 1 driver, Matejka says.

The prime minister had hoped to rally the troops behind her with a speech earlier this month at the Conservative Party’s conference, but the address was marred by a prankster on stage, a coughing fit, and a backdrop that literally fell apart, as letters dropped from a Tory slogan. May has soldiered on, leading to renewed confidence that she can hold on to cabinet support for her plans for leaving the European Union. Nonetheless, when there are domestic wobbles, investors end up feeling uncomfortable about the U.K.’s bargaining power in the Brexit negotiations, Matejka says.

The divorce talks with EU officials appear to have arrived at a standstill, with the trade bloc’s chief negotiator, Michel Barnier, saying Thursday that not enough progress had been made to recommend that the discussion proceed to the EU and U.K.’s future trade relationship. However, Barnier may offer a two-year transitional Brexit deal.

“One can have one view or the other on the eventual outcome, but just the process itself will not reassure business leaders, and therefore that will act as a dampener,” Matejka told Barron’s.

During the past week, the International Monetary Fund warned that the U.K.’s “medium-term growth outlook is highly uncertain and will depend in part on the new economic relationship with the EU.” But the J.P. Morgan strategist says such downbeat releases won’t influence investors that much, while others are even more dismissive.

“It’s sort of like the ratings agencies a number of years ago: If some of the calls you’re making aren’t that accurate, traders tend to pay a little less attention to it,” says David Madden, a market analyst at CMC Markets in London.

Certain British stocks could be especially worth avoiding. Matejka predicts that so-called bond proxies won’t do well as central banks change their tunes. Other analysts are also downbeat on those plays, with Kathleen Brooks, City Index’s research director, saying she is bearish on utilities. She says another factor in that call is the U.K. government’s efforts to put a price cap on electricity and gas bills.

“Even though they have been one of the weakest sectors so far this year, this price-cap legislation could really knock them,” says Brooks. Utility stocks on the FTSE include Centrica

CNA, -2.46%

National Grid

NG., -0.82%

Severn Trent

SVT, -1.59%

SSE

SSE, -1.21%

and United Utilities Group

UU., -1.11%

This article first appeared at Barrons.com on Oct. 13.