FLGB: Staying Cautious On The UK Forward Of Extra Tightening (NYSEARCA:FLGB)

Amid a few of the worst stagflationary pressures (excessive inflation and slower progress) in Europe, the near-term backdrop for the Franklin FTSE United Kingdom ETF (NYSEARCA:FLGB), a basket of the UK’s largest shares by market cap, stays lower than stellar. Since I last covered the title, FLGB has given up a few of its YTD features; but valuations stay removed from low-cost at ~10x earnings vs. consensus estimates for an earnings decline this yr. Additional including to the valuation stress is the prospect of an prolonged financial tightening cycle by the Financial institution of England (BoE), as elevated core inflation ranges threaten to derail the Prime Minister’s goal to halve inflation by year-end. With an exterior slowdown additionally looming giant, together with wage progress pressures and tighter lending requirements, FLGB’s portfolio corporations might see extra downward revisions to earnings from right here. Forward of a possible 25-50bps hike at this month’s BoE assembly, I would stay significantly cautious.

Fund Overview – A Low-Price and Properly-Diversified Car for UK Publicity

The NYSE-listed Franklin FTSE United Kingdom ETF tracks (pre-expenses) the efficiency of the market cap-weighted FTSE UK Capped Index, a basket of UK large-cap shares topic to weighting caps. The ETF has seen its web belongings decline to $572m (vs. $576m prior) on the time of writing amid fairness declines in latest months. The place FLGB continues to face out is its ultra-low 0.1% expense ratio – by comparability, the iShares MSCI United Kingdom ETF (EWU) and the First Belief United Kingdom AlphaDEX Fund (FKU) cost 0.5% and 0.8%, respectively.

The fund’s sector allocation has shifted barely in latest months – essentially the most notable change is the elevated Financials weighting at 18.5%, changing Client Staples as the biggest sector publicity. The Well being Care allocation (12.0%) has additionally declined compared to Industrials (12.4%) and Power (12.2%), with Supplies remaining the one different sector over the ten% threshold. Regardless of the single-stock limits, the fund’s top-five sector exposures stay comparatively excessive at a mixed ~73% of the portfolio, so traders will must be aware of the focus danger right here.

The ETF’s single-stock holdings stay comparatively constant, with pharmaceutical/biotech multinational AstraZeneca (AZN) nonetheless the biggest allocation at 8.2% (unchanged), adopted by oil and gasoline firm Shell plc (SHEL) at 8.0% (unchanged). Banking group HSBC Holdings plc (HSBC) is essentially the most notable gainer at 6.4%, adopted by shopper items firm Unilever (UL) and one other oil and gasoline multinational, BP plc (BP). The weighting caps stop any outsized single-stock exposures within the 111-stock portfolio, so traders on the lookout for well-diversified UK publicity will discover quite a bit to love in FLGB.

Fund Efficiency – Underwhelming Lengthy-Time period Monitor Document; Strong Yield

FLGB has gained ~12% in NAV phrases this yr, boosted by a robust rally in March/April. Since then, nonetheless, the fund has begun to endure a gradual decline, weighing on its since inception returns (at the moment +3.4% annualized). On a five-year timeline, the +2.8% annualized return hasn’t been nice both, although the fund’s robust post-COVID rally has propped up its one and three-year returns at +14.1% and +11.9% in NAV phrases, respectively. For essentially the most half, FLGB has tracked comparable ETFs like EWU via the cycles, although its industry-low expense ratio has made a slight distinction over longer timelines.

The stable ~4% distribution (per final yr’s ~$0.97/share payout) will enchantment to revenue traders as effectively. And with H1 2023 additionally coming in strongly on distributions, I am anticipating one other yr of stable payouts. Over the long term, although, FLGB’s emphasis on cyclical power and materials shares provides some cyclicality to the payout, so traders will wish to be aware of the swings. Nonetheless, the fund’s monitor report suggests it ought to have little problem paying out a low-single-digit yield via the cycles; therefore, income-focused traders will discover quite a bit to love right here.

Stagflation Considerations Cloud the Outlook for Equities

Macro considerations within the UK have been high of thoughts in latest months, as ‘sticky’ and elevated inflation ranges have been met with a steep rise in rates of interest. Whereas the speed hikes over the past yr have not had a lot of an influence on labor market tightness (but), it has begun to hit the buyer by way of mortgages, compounding the cost-of-living disaster all through the UK. The labor market’s collective bargaining powers have been a key differentiator towards different developed markets, with ongoing strike actions driving wages larger and weighing on total productiveness. In tandem, main financial indicators paint a bleak image – most notably, PMI numbers are down throughout the board on the again of decreased new orders and backlogs. With home banks additionally tightening lending requirements and the property market beginning to see the (lagged) influence of the BoE’s hikes, all indicators level to an extra slowdown in H2. But, the BoE has made it clear that its near-term precedence is inflation, and thus, the ‘sticky’ providers inflation stress (regardless of the decelerating headline quantity) and robust labor market information imply one other massive price hike might be on the desk on the upcoming BoE coverage assembly.

To be clear, a few of the negatives could be priced in – the UK fairness market has begun to present again a few of this yr’s outperformance in latest months amid persistent stagflationary pressures all through the area. Unfavorable YoY comps (recall the excessive commodity and oil worth base from final yr) do not assist, whereas the dearth of publicity to tech improvements (e.g., synthetic intelligence) has saved a lid on total earnings progress (at the moment pegged at -10% this yr and +4% in 2024). Lastly, FLGB’s portfolio of UK multinationals, a lot of which derive a big chunk of their revenues from exterior of the UK, stay uncovered to an exterior slowdown globally. And with an prolonged BoE tightening cycle on the horizon, the ever-increasing yields from mounted revenue alternate options will add stress to fairness valuations.

Staying Cautious on the UK Forward of Extra Tightening

UK equities might have began the yr on the fitting foot, however a few of the outperformance has light following a slew of adverse macro information (domestically and abroad). Probably the most regarding development right here is the one-two punch of ‘sticky’ core inflation and weaker progress (i.e., stagflation); in flip, the BoE has been compelled into one of many steepest price hike cycles in many years. In contrast to comparable developed market ETFs within the US and Europe, the UK additionally lacks tech-driven innovation tailwinds (notice FLGB solely has a ~1% tech allocation), eradicating key optionality from long-term earnings forecasts. But, the present ~10x P/E valuation is not all that low-cost if you consider consensus estimates for a ~10% contraction this yr (+4% subsequent yr). And with the BoE additionally dedicated to taming inflation, a larger-than-expected hike might effectively be on the playing cards at this month’s coverage assembly. Web, I stay sidelined.