A poor economic backdrop will see UK stocks trail their overseas peers

IT&rsquo;S hard to be optimistic about Britain&rsquo;s economy. It lags behind both France and Germany in exiting recession and a sharp contraction in industrial output in September cast doubt over how positive third quarter GDP data &ndash; released this Friday &ndash; will be. A slow and protracted recovery lies ahead, according to the Bank of England, which may loosen monetary policy further next month at a time when other central banks are thinking of tightening. And policies to bring Britain&rsquo;s spiralling public debt under control are likely to remain on an uncertain footing until the general election. <br /><br />And as if it couldn&rsquo;t get more miserable for British firms, a weak pound will see their import costs stay high and a depressed UK consumer hit their domestic sales. So with all this pessimism surrounding the state of the British economy at the moment, could it be prudent for investors looking for returns to either avoid the UK altogether or be particularly unpatriotic and sell British stocks?<br /><br />Morgan Stanley analyst Teun Draaisma is at pains to point out in his latest research that the UK stock market is not the UK economy. &ldquo;However, the UK stock market has only a limited exposure to the domestic economy &ndash; we calculate that just 35 per cent of UK stock market revenues come from Britain versus 43 per cent from other developed regions and 22 per cent from emerging markets,&rdquo; he says. <br /><br />So although too much household and government debts, combined with a fragile banking system will mean that the UK economy is likely to trail its global peers in the coming years, a pullback in UK stocks is not necessarily on the cards. <br /><br />Many multinational firms choose to list, or at least dual-list, in London because of its continued reputation as an international centre for finance and therefore are not as exposed to the UK economy. <br /><br />What&rsquo;s more, the FTSE 100 is heavily weighted towards oil and gas firms as well as miners. These tend to derive their revenues from either offshore projects in the case of the former, or overseas projects in emerging economies in the case of the latter. Therefore, it is more likely to be retailers, pub companies and UK-based manufacturers that will be stung by the poor economic state. Investors still looking to buy British might therefore do better to avoid these sectors when building their portfolio.<br /><br />However, UK equities tend to lag at the start of a new growth cycle so they are likely to underperform their global counterparts. And in general UK equities tend to underperform in periods when global stock markets are rising &ndash; this is especially the case in terms of relative performance against the MSCI Europe ex-UK index. The perceived defensiveness of the UK stock market is supported by its lower beta &ndash; Morgan Stanley calculates the beta of the MSCI UK (compared to the MSCI World) is currently 0.86 compared to a beta of 1.02 for MSCI Europe ex-UK. Beta measures how much a security fluctuates relative to a benchmark. If beta is less than one, then the security will move less wildly than the wider markets and vice versa for more than one.<br /><br /><strong>IMPORT COSTS</strong><br />But while a weak sterling might seem like bad news for the UK in terms of rising import costs, it can be a positive factor for UK equities. Almost half of UK market earnings (and 45 per cent of market dividends) come from companies that report in US dollar, so a 15 per cent depreciation in sterling-dollar adds 7 to 8 per cent to UK earnings per share. <br /><br />The weak sterling could also boost mergers and acquisitions (M&amp;A) activity in a number of sectors including telecoms, pharmaceuticals and materials, says Ronnie Chopra, which could see Cable and Wireless targeted by either Deutsche Telecom or France Telecom; J Sainsbury by the Qatar Investment Authority; or Smith &amp; Nephew by Johnson&amp;Johnson or Procter&amp;Gamble. With UK firms being the subject of takeover rumours and bids, their shares could surge on the back of any such talk, boosting the overall market. <br /><br />Nonetheless, while an increase in investor concern over the UK economy and political situation is unlikely to be a big negative for UK equities, it will not help given that the British stock market historically underperforms in the early stages of a new global growth cycle. <br /><br />As such, investors wanting returns should look elsewhere &ndash; perhaps towards emerging markets &ndash; and ensure their portfolios are slightly underweight on Britain. <br />