By Kit Rees
LONDON (Reuters) - Despite a torrid start to 2018 and with Brexit uncertainties looming large, British blue-chip stocks have jumped to record highs thanks to a weak pound, a torrent of mergers and acquisitions, and bouts of political anxiety in the euro zone.
The benchmark FTSE 100 (FTSE) and mid cap 250 index (FTMC) both bounced back in May from lows hit in March, undaunted by two critical Brexit-related events - a vote on the European Union withdrawal bill in parliament next week and a summit of the bloc's leaders at the end of this month.
Investors are reconsidering the attractions of UK-listed equities relative to those in the euro zone for a combination of reasons. Sterling
On top of that expectations of a long-awaited interest rate increase by the Bank of England are receding and stock valuations are relatively attractive. The disproportionate weighting in FTSE indexes of energy and mining firms has also helped due to buoyant global oil and metals prices.
At the same time, the re-emergence of political uncertainty in Italy and Spain has encouraged investors to reassess their euro zone holdings.
While euro zone stocks (STOXXE) ended May with a 2.5 percent loss, the FTSE 100 was the best regional performer, gaining 2.2 percent and returning to positive territory for the year. It was down as much as 10 percent as recently as March.
In some respects, the FTSE is playing catch-up as it underperformed both continental European and U.S. stocks last year. But many investors who have been underweight UK stocks for some time have reconsidered relative positioning, regardless of Brexit and its uncertain consequences.
"The UK was more or less ticking all of the negative boxes which is why so many fund managers were underweight," Fabrice Theveneau, head of equities at Lyxor Asset Management, said.
"Now it is progressively changing," he added, saying in a recent interview that his Lyxor Sustainable Equity Europe fund has been reducing its underweight position on the UK market.
May saw the biggest back-to-back monthly increases in allocation to UK equities since before the Brexit vote, despite remaining "the consensus short", according to Bank of America (NYSE:BAC) Merrill Lynch's latest fund manager survey.
BAML's cross asset strategists have also rotated out of Europe and into British equities, which they see as a better bet in the later stages of an economic expansion thanks to the London market's large weighting in energy, materials and defensive stocks such as health and consumer staples firms.
DIVORCE TALKS
British equities have had a tough time amid uncertainty surrounding the EU divorce talks. So far 2018 has seen the demise of outsourcer Carillion (L:CLLN) as well as troubles for high street stalwarts Mothercare (L:MTC), Carpetright (L:CPRC) and Debenhams (L:DEB), to name a few, as inflation puts pressure on consumer spending.
The comeback has been driven, or at least accompanied, by a flurry of M&A activity. This has hit an all-time year-to-date record in 2018 with the total value of UK deals standing at just over $260 billion, according to data from the Thomson Reuters Deals Intelligence team. https://tmsnrt.rs/2L8oWBe
Overseas buyers have been lured by the weak pound, with Takeda of Japan (T:4502) acquiring pharma firm Shire (L:SHP) for $62 billion.
British supermarket Sainsbury's (L:SBRY) is also planning a $10 billion (7.44 billion pounds) acquisition of Walmart's (N:WMT) UK-based Asda, and banking group CYBG (L:CYBGC) has bid for rival Virgin Money (L:VM).
Last month shares of IWG (L:IWG) rocketed after the serviced office provider said it had received takeover approaches from three suitors, while on Tuesday Rupert Murdoch's Fox (O:FOXA) received approval to buy Sky (L:SKYB) on condition it sold Sky News.
Theveneau said Lyxor Asset Management's biggest overall position in its portfolios is in Shire (L:SHP).
Some big names have also tempered their sell recommendations on UK equities. Morgan Stanley (NYSE:MS) upgraded its view in May, while Deutsche Bank (DE:DBKGn), Citi and UBS Wealth Management all lifted their recommendations for UK stocks in April.
Justin Onuekwusi, multi-asset fund manager at Legal & General Investment Management, says his firm too has been reducing its underweight in UK stocks in its Multi-Index funds, although for risk-management reasons. Overall, Onuekwusi says that he is not all that positive on UK equities on a medium-term perspective.
"You've got Brexit hanging over the UK, and although we can debate the impact on long-term earnings of UK companies, the immediate transition mechanism for Brexit risk will be through the currency," said Onuekwusi.
"We expect sterling to continue to be volatile if there is uncertainty and that in turn will have an impact on the UK stock market."
But some investors are hoping the worst is now over.
"Over the last two years domestic UK - particularly retail - has come under pressure in stock market terms (with) lots of profits warnings and a few high-profile casualties," Stephen Macklow-Smith, head of Europe equity strategy at JPMorgan (NYSE:JPM) Asset Management, said. "We think there's scope for that to improve this year."
Graphic: UK stocks - back in the black: https://reut.rs/2LnNlTJ