FTSE 100's 21% Discount Faces Hurdles, BOE Cut May Aid

Key Takeaway

• FTSE 100 is undervalued by 21%, but structural issues and index composition hinder closing the valuation gap.
• UK stocks' long-term underperformance compared to US markets, with a significant shift in pension fund investments away from UK equities.
• Potential BOE rate cuts could boost appeal for higher-yielding UK stocks, despite existing challenges.

UK Stocks at a Discount

The FTSE 100 is currently valued at a 21% discount compared to its fair value of 10,479, based on a long-duration bond valuation methodology. This undervaluation starkly contrasts with the US markets, where the Nasdaq 100 and S&P 500 trade at premiums to their estimated fair values. Despite the attractive pricing, structural issues such as pension fund underinvestment and the index's composition heavily weighted towards sectors like industrial goods and utilities, rather than technology, hinder the closing of this valuation gap.

Structural Challenges Persist

Over the past 25 years, UK pension investment in domestic equity markets has dramatically decreased from 53% to just 6% of total assets, equating to a GBP1.9 trillion withdrawal. This lack of "home bias" is notable when compared to other countries like Canada, where pension funds are significantly overweight in their domestic market. The FTSE 100's composition, with a minimal presence of technology stocks, further diminishes its appeal to investors, especially when compared to the tech-driven rallies seen in the US markets.

Potential BOE Policy Support

The Bank of England (BOE) is considering cutting its policy rate, which is currently seen as restrictive, by 50 basis points by the end of the year. Such a move could enhance the attractiveness of higher-yielding stocks, with the FTSE 100 offering a prospective earnings yield of 8.4%. This potential rate cut, aimed at stimulating the economy, could provide much-needed support to UK stocks, making them more appealing to investors.