LONDON Stocks have never been higher, the economy is far stronger than most had predicted and the apocalyptic recession forecasts have been quietly withdrawn. Yet for all that, investor pessimism about UK markets runs deep.
Nearly seven months after Britain's vote to leave the European Union, money managers are reluctant to hold any significant exposure to UK Plc, betting that the currency will weaken further and bond yields will continue to rise.
Although the rise in the benchmark FTSE 100 index .FTSE and smaller mid-cap FTSE 250 .FTMC to all-time highs suggests investors are showing some love to UK stocks, that's largely just the flip side of the extremely gloomy view on the sterling exchange rate because around 70 percent of FTSE 100 company earnings come from overseas.
In fact, UK equity fund outflows last year were the third largest in Europe after German and French redemptions, according to data providers EPFR Global, most of that after the June 23 Brexit vote.
Matthias Hoppe, a cross-asset portfolio manager at Franklin Templeton Solutions (FTS) in Frankfurt, went into the Brexit referendum with minimum UK exposure. It's a position he maintains.
"We are trying to avoid UK equities in some of our multi-asset funds. Given the cheap currency, names within the FTSE 100 could be attractive, and they have one of the highest dividend yields in the world. But as long as there is uncertainty about Brexit and the consequences of trade agreements and so on, we only have a very light exposure," Hoppe said.
Talks between Britain and the EU over the divorce proceedings are due to open before the end of March, when Prime Minister Theresa May is expected to trigger Article 50 of the EU's Lisbon Treaty.
The negotiations that follow will be some of the most complicated in the region since World War Two. There remains huge uncertainty over immigration, trade ties, access to the EU's single market and freedom of movement of labour, capital, goods and services.
Hoppe, who manages $2.2 billion of assets in the wider FTS portfolio of $40 billion, is equally wary of sterling and UK government bonds.
"For gilts, inflation in the UK is going to be higher, so we have no exposure to them," he said.
A comparison of investors' exposure to UK assets now versus the period around the referendum is outlined below.
Chicago futures market data show that speculators held a fairly large net short sterling position of around 50,000 contracts going into the referendum.
That increased to almost 100,000 contracts in October around the time of the sterling "flash crash", the biggest net short position in the data's 20-year history.
It has since shrunk, but never below referendum levels. The latest data show the position at around 65,000 contracts. With the pound at its lowest since October around $1.21 GBP=, those bearish bets could get bigger.
(CFTC graphic: tmsnrt.rs/2ifsxyz)
Bank of America Merrill Lynch's (BAML) monthly fund manager surveys show that short sterling positions were the largest in the surveys' history in the months after the referendum, peaking in November. Sterling was also its most undervalued on record in the November survey.
A Reuters poll this month showed that FX analysts are gloomier on sterling now than they were in December.
Currency analysts at HSBC said this week that "fair value" for sterling if there was no Brexit would be around $1.55. A "hard" Brexit, in which immigration controls would take precedence over access to the single market, would see it fall to $1.10.
According to BAML's fund manager survey in June last year, investors were 23 percent underweight UK stocks relative to benchmark. That increased to 27 percent in July, and fund managers said they were looking to have the largest UK short position since December 2009.
The August survey showed that 53 percent of those surveyed said Britain was the most favoured equity underweight (UW) over the coming year, by far the biggest single UW position.
That net UW position was 35 percent relative to their benchmark in November, the biggest since May and approaching levels seen at the height of the global financial crisis when U.S. investment bank Lehman Brothers collapsed in 2008.
It was scaled back in December, but the UK remains the most underweighted region globally for over 9 months, BAML said.
Fund flows data from EPFR show that there have only been a handful of weekly inflows into UK equity funds since the referendum, all of them extremely small. But the pace of outflows since June has been slowing, suggesting sentiment may be improving.
(EPFR UK fund flows: tmsnrt.rs/2jCMDbl)
Money managers are gloomy on UK government bonds. Bank of England figures published last week showed that while overseas investors are buying at the fastest pace since comparable records began over 30 years ago, UK investors are selling at the fastest pace ever. Domestic investors' selling outweighed foreigners' buying by a rate of nearly 2:1, figures showed.
That's because domestic investors have been quick to offload their bonds to the BoE, which has been a guaranteed buyer since it resumed quantitative easing bond purchases. Overseas holders, meanwhile, have doubled down on gilt purchases to take advantage of falling prices and because some, such as FX reserve managers, are mandated to keep their sterling reserve levels steady.
In June, UK accounts' rolling three-month total gilt purchases topped 28 billion pounds. That flipped to 67.7 billion pounds of selling by November, a record.
Overseas investors were buying gilts at the fastest pace on record in November, with the three-month rolling total nudging 40 billion pounds. It was around 12 billion pounds in June.
(UK gilt flows graphic: tmsnrt.rs/2ifttTP)
The 10-year gilt yield is now around 1.35 percent GB10YT=RR, roughly where it was on the day of the Brexit referendum. It plunged to a record low 0.55 percent in August, just around the time the BoE cut interest rates to a record low 0.25 percent and revived its bond-buying quantitative easing stimulus programme.
(Graphics by Jamie McGeever and Andy Bruce; Editing by Sonya Hepinstall)