UK equity markets began the quarter on a positive note, but trading activity was subdued in the lead-up to 23 June, the day the British public voted to leave the EU. With polling and betting odds largely pointing to a Remain victory immediately ahead of the ballot, UK markets initially took the news badly – although they recovered somewhat to finish only 3.1% down by the end of that week. Among the worst affected were banking stocks, with Lloyds, Barclays and Royal Bank of Scotland tumbling on the day of the result. House builders shed a quarter of their value amid fears of a slowing economy and a tightening in mortgage lending criteria.
For the quarter as a whole, the globally-focused FTSE 100 was actually up 6.5% in local currency terms and the FTSE All Share rose 4.7%. Sterling sank 7% against the dollar over the three months, a move which benefits stocks with significant overseas earnings, such as Unilever and GlaxoSmithKline.
House builders shed a quarter of their value amid fears of a slowing economy and a tightening in mortgage lending criteria.
Overseas earnings account for around 77% of the FTSE 100. High dividend-yielding UK stocks such as Reckitt Benckiser and National Grid also fared well, rising more than 14% in the week following the referendum.
By contrast, the FTSE 250 index of mid-cap companies struggled. It ended the quarter 5% below the level it had reached on the day of the referendum, given the greater exposure of many companies to the domestic economy. Our holding in Howden Joinery was dragged down with UK house builders, ending the quarter down 16%.
Before the vote, UK gross domestic product (GDP) growth was around 2%, having recovered from the sub 1% rates seen back at the end of 2013. We now expect growth to be at least 1% weaker next year, as companies think twice about hiring new staff and investing in the uncertain environment. It will take time to recognise the full implications of the vote to leave the UK. The uncertainty alone is likely to have a substantial negative effect on the economy – with early figures concerning consumer confidence disheartening.
US equities returned 2% (10% in sterling) in the quarter, driven by continued recovery in the US energy sector. The period saw the price of crude oil rise by more than $10 per barrel to reach almost $50, the highest level since last October. Perhaps unsurprisingly then, energy was the strongest-performing sector, climbing by nearly 11%.
Domestic earners outperformed as investors shied away from more internationally exposed comapanies vulnerable to renewed strength in the dollar.
Other sectors that led the pack included utilities, telecoms and healthcare as investors sought the safe, predictable returns from defensive areas of the market. By contrast, the worst performer was technology, where there were a number of disappointing first-quarter results, including those from Microsoft, Alphabet and Apple.
At the end of the quarter, US equities were caught up in the global sell-off sparked by Brexit. Domestic earners outperformed as investors shied away from more internationally exposed companies vulnerable to renewed strength in the dollar.
Meanwhile, German chemicals giant Bayer made a $54bn takeover bid for US agrochemicals group Monsanto, although Monsanto is in talks with other suitors.
Underlining the fact that Brexit is not just an issue for Britain was the turmoil witnessed in European markets in the aftermath of the vote. For the quarter overall the FTSE AW Europe Ex UK index was broadly flat, with the French CAC down marginally, by 0.6%, and Germany’s DAX declining 2.9%. For UK-based investors the picture is brighter, thanks to favourable currency movements.
The European Central Bank (ECB) continues to support markets with loose monetary policy. From the referendum date to the end of June, the euro weakened by 2.2% against the dollar, which is likely to be welcomed by ECB President Mario Draghi as a boost to exporters. Despite this, our expectation for growth in the eurozone has nudged down given the likelihood that both businesses and consumers will delay spending while the uncertainty persists.
The European Central Bank (ECB) continues to support markets with loose monetary policy.
At a sector level, European pharmaceutical companies rebounded strongly over the quarter following a weak start to the year. Sanofi, Roche and Novartis enjoyed double-digit returns as worried investors piled into high quality, defensive healthcare names. Alongside Brexit worries, Italy is grappling with its precarious banking sector, the migrant crisis is unresolved, sovereign debt levels remain high, and recent events in Istanbul remind us of the undiminished threat from terrorism.
In January the Bank of Japan adopted negative interest rates to shore up growth and inflation. While such monetary easing would normally be expected to weaken the currency, thereby creating demand for more competitively priced exports, perceived problems in other regions drove a ‘flight to safety’ by international investors and a sharply stronger yen over the quarter. The rise in the yen hurt shares in big exporting companies like Toyota and Canon.
Meanwhile, worries over Chinese growth, which were front and centre of investor concerns for Asia generally in the first quarter, dissipated somewhat, helped by economic stimulus and the stabilisation of the yuan. This helped stem the surge of capital outflows from China that had marked the start of the year, and their foreign exchange reserves also steadied. While the Chinese economy is slowing as it moves from a dependence on capital spending and manufacturing to more consumer-based growth, we still see growth continuing to be much higher than many other major countries.
One of the best-performing markets over the quarter was India, which benefited from continued easy monetary policy in the West and China’s stabilisation. Prime Minister Modi’s easing of rules on foreign direct investment was received particularly well. They were seen as evidence of the continued liberalisation of the Indian economy to help improve its infrastructure.
UK government bonds moved into unchartered territory in the second quarter, with the yield on ten-year debt slipping below the 1% threshold in late June for the first time, to 0.79%. Demand spiked as investors sought havens amid the Brexit volatility, as fears of a UK recession grew and as markets began to price in the possibility of an interest-rate cut.
We believe both the BOE and the government’s first concern will be the economy.
While we do not know what the long-term impact of the vote will be on the economy, what we do believe is that the collapse in sterling – to a 31-year low – will cause inflation to be imported from abroad. We also see the price of oil (incidentally, denominated in dollars) ceasing to be a downward drag on inflation. These factors combined are likely to result in an inflationary spike – bond investors’ biggest enemy.
To tame inflation the standard policy response of the Bank of England (BOE) is to increase interest rates – an action which will simply place additional challenges on an already fraught economy. We believe both the BOE and the government’s first concern will be the economy. As such they are likely not only to allow inflation but, through policies designed to stimulate the economy, create it.
Markets are currently pricing inflation to average 3% per annum for the next 20 years, and with the 20-year government bond yielding only 1.5%, long-term investors are guaranteed to lose purchasing power. This is far above today’s inflation rate of 0.3%. We see inflation protection as an important component of portfolios. This is accessed (selectively) through both inflation-linked bonds and successful companies with pricing power.
The source data for each graph is supplied by Thomson Reuters Datastream, as at 30 June 2016 total return, local currency unless otherwise stated.