By Naomi Rovnick
LONDON (Reuters) - Britain's economy might well have fallen into recession late last year, money has exited UK stocks and fears about unsustainable borrowing that have resurfaced ahead of a March 6 budget may stick until an election expected later this year.
But the prospect of a change in government that lifts sentiment towards the economy has seen investors debating whether UK markets are too cheap. An expected victory for the EU-friendly opposition Labour Party may lift sterling, while - regardless of the election outcome - looming rate cuts should lend support to government bonds, or gilts.
"As we go through the year and get more clarity on where we are in terms of politics, some rate cuts, we'll get a realization of the value that exists in the UK," said Neil Birrell, chief investment officer of London-based asset manager Premier Miton. "It could be one of the best performing markets of the year."
Here's a look at how investors view UK markets:
BONDS: VALUE OR VIGILANTES?
Bond markets, which influence debt costs and economic growth, are wary for now.
Ten-year gilt yields, which rise as their price falls, are around 4.1%. They have soared 52 basis points (bps) so far this year, while German and U.S. peers are up 30 bps each.
Britain's national debt is almost 100% of gross domestic product and finance minister Jeremy Hunt has hinted at pre-election tax cuts in his March budget, prompting a warning from the International Monetary Fund.
Pictet Wealth Management chief investment officer Cesar Perez Ruiz said any unsustainable pre-election spending by the Conservative government or after an election win by Labour, leading in opinion polls, would bring back "bond vigilantes".
That's a reference to a market rout in 2022 after a largely unfunded mini-budget and tax cuts by then-Conservative prime minister Liz Truss' government sparked a surge in borrowing costs and mortgage rates, shattering Britain's reputation for financial stability.
"We are negative on gilts and on sterling," Perez Ruiz said.
Some other big investors were positive on gilts given the prospect of rate cuts as inflation subsides. Markets fully price in a 25 bps rate cut in August.
Ed Hutchings, head of rates at Aviva (LON:AV) Investors, expected gilts to outperform on a cross-market basis, noting that there could be value in gilts that investors fretting about politics had not spotted.
'BREXIT POUND'
Sterling has gained almost 2% against the euro this year and speculators hold one of their largest bullish positions in the pound of the last decade.
Barclays (LON:BARC) senior foreign exchange strategist Lefteris Farmakis said the disruptions to trade and the economy caused by Brexit mean sterling trades with a long-term discount that closer trading links with Europe could reverse.
Labour leader Keir Starmer has pledged to strengthen ties with the European Union if his party wins the election.
Farmakis tips sterling to "peak ahead of the election in anticipation of closer ties with Europe", then to fade once markets acknowledge the complexities of hammering out a new relationship.
STOCKS - FOREVER LOST?
UK stocks are unpopular, trading at a 35% discount to global peers, with this valuation gap near its widest in decades. Before 2016 UK equities traded at a premium.
Just over $36 billion flowed out of UK equity funds in 2023, almost triple the amount lost in 2016 and the most since at least 2008, according to fund tracker Morningstar.
European travel operator Tui is quitting the London stock market, while merger activity driven by cheap valuations is revving up.
Pictet's Perez Ruiz said he was screening the UK-focused FTSE 250 index for companies that might become takeover targets.
"The UK equity market, relative to others and to its history, is attractive on valuation grounds," Premier Miton's Birrell said, adding that political stability might revive investor interest.
When Rishi Sunak became prime minister in October 2022, following Truss' disastrous budget, he was the third British leader in less than two months; Hunt became the fourth finance minister in as many months.
"We couldn't have had a more unstable period since 2016," for UK stocks, said David Stevenson, who manages portfolios of small and mid-cap UK companies at Amati Global Investors.
He added that some "normalisation" -- in politics, interest rates or economic growth-- would improve sentiment.
"The UK market is cheap but everybody knows that, and what everyone is waiting for is a catalyst to get involved, and once that starts the rebound from here could be huge."
($1 = 0.9293 euros)