Undoubtedly, major global stock indices have exhibited remarkable performance since the beginning of the year, with tech companies being the main driving force behind this rally. However, the FTSE 100 index, which was the sole survivor of the 2022 global selloff, has been massively underperforming for a wide range of reasons. Are UK stocks extremely cheap at the current levels or is there limited growth potential in the economy?

Idiosyncratic reasons behind underperformance

Last year, the UK stock market had a stellar performance despite the country’s lagging economic recovery, exceptionally high inflation and political instability. This was mainly attributed to the FTSE 100’s composition, which is overloaded with healthcare, energy & mining and financial stocks. These three non-cyclical sectors benefited as healthcare became the number one post-pandemic priority, commodity prices went through the roof after Russia’s invasion of Ukraine, while financial institutions gained on the back of increasing interest rates.

As expected, the FTSE 100 lost its shine when all the aforementioned themes subsided, but its underperformance lies in more than that. The latest rally observed in equity markets is mainly driven by the AI hype, thus the absence of major tech stocks is largely weighing on the FTSE 100. Moreover, the unexpected banking turmoil following the collapse of four US regional banks contributed significantly to the index’s weakness due to its high exposure to banking stocks.

Historically cheap

From a valuation perspective, it is reasonable for the FTSE 100 to retain significantly lower multiples against its US counterparts due to being overloaded with non-cyclical companies with limited growth prospects. However, it is worrisome that its 12-month forward Price-to-Earnings ratio, which denotes the dollar amount someone would need to invest to receive back one dollar in annual earnings, currently stands at 10.3x very close to levels observed only after the pandemic outbreak.

Much of this weakness could be attributed to increasing fears over a recession, with declining oil prices backing this development. Generally, oil prices act as a leading indicator for the health of the economy, while the recent slump is suggesting weaker demand in the future due to fears of a recession. Therefore, the discount in the FTSE 100’s valuation could be the product of its outsized exposure to energy and commodity-related stocks.

Finally, the index has also recorded some volatile sessions following data releases or major developments coming from China. However, the Chinese economic picture remains blurry as the latest disappointing PMIs could be offset by both the PBOC’s and the government’s commitment to provide stimulus.

Interest rates have a long way to go

The UK is facing the largest inflationary pressures among the G7 nations, which by itself should be enough for the Bank of England to keep raising interest rates aggressively. Lately, remarks by the CBI that the UK economy will most likely avoid a recession this year increased the probability that the BoE could match market expectations and deliver a total of 100 basis points worth of additional rate increases till the end of the year.

High interest rates for a prolonged period could prove to be a double-edged sword for the UK stock market. On the one hand, they directly reduce the value of the firms' future cash flows, while borrowing to fund investments becomes unattractive. Moreover, the pound could keep strengthening due to interest rate differentials, delivering a huge blow to the export-heavy UK benchmark, which derives approximately 75% of its revenues overseas.

Technical levels to watch

The UK 100 stock index experienced a massive slump since late April, which came to a halt at the June low of $7,445. However, the price has been trading sideways during the past two weeks, looking unable to pierce through the $7,655 zone.

Hence, if the short-term weakness persists, immediate support could be met at $7,535, which is the 38.2% Fibonacci retracement of the $6,707-$8,047 uptrend. A violation of that zone could open the door for the recent low of $7,445.

On the flipside, should the price edge higher, the $7,655 hurdle could prove to be the first one for buyers to clear before the 23.6% Fibo of $7,730 gets tested.