Well, we were not expecting that! I refer not to the vote to leave the European Union, but to the aftermath of that decision and the fact that the FTSE 100 finished the subsequent week up nearly 4%. Neither outcome was in the script. But on reflection, perhaps the second of these surprise outcomes should have been more predictable; after all, multiple international monetary regimes have been engaged in a protracted and costly race to the bottom with their respective currencies. The effect of the Brexit vote was that overnight it allowed sterling to leapfrog other players and scale the devaluation league tables. With nearly three quarters of FTSE 100 revenue earned overseas, the mechanical positive effect on earnings is relatively straightforward to compute and understand (see following chart). The more nebulous negative impact of an inevitable fall in confidence – corporate and consumer – both in the UK and elsewhere, is very much more difficult to compute, but indisputably very significant.
The beginning of the beginning
Within this overall positive move for the market in the week following the Brexit vote, there have been huge sector performance divergences. The international, US dollar-denominated sectors – oil & gas, mining, pharmaceuticals, most consumer staples – are doing very well, but domestically orientated cyclicals – financials, retailers, house-builders, property and leisure – are doing very badly, losing typically between one fifth and one third of their value in very short order.
In a market predisposed to shoot first and ask questions later, this would suggest plenty of opportunity to take advantage of investor over-reaction. I would caution, though, that it is incredibly early days; we are only at the beginning of the beginning (apologies to Winston Churchill) and of course for those companies venturing a comment and saying that they have seen nothing yet, of course they won’t have done. It is not like flicking a light switch, dark and then light. But confidence is bound to have been affected; consumers will be a little more circumspect about their own wage and job security prospects. And singularly not helping the situation has been the farcical political fallout post the vote, just when the market required firm political leadership.
Brexit – and broader issues
We are, though, where we are and we need to deal with it. And whilst the self-inflicted harm of Brexit is grabbing the headlines in the short term, we should not be distracted from all the pre-existing macro and political concerns: China on a credit-fuelled knife edge, still anaemic US growth after trillions of dollars of quantitative easing, Greek and Portuguese debt, Italian banks, failing oil-states, terrorism and the forthcoming US election.
The first of these should leave us still wary about the mining sector, the second wary of the very rich valuation attached to Wall Street, and the European contingent wary of expecting any material and sustainable recovery across the continent any time soon. The hit to confidence that Brexit and the subsequent politics brings will affect banks via lower business activity levels, lower loan growth, higher loan losses and rates staying lower for longer. This latest knock to the sector comes just too soon into their slow, painful recovery from the global financial crisis, after the regulators and litigators have taken their pound of flesh, but before shareholders have seen the benefit of cleaned-up balance sheets.
Lest the above gives the impression that it is all gloom and doom, there are still some more positive areas of the market. Aside from the obvious big US dollar-earners, there are a number of less well-loved, quality mid-sized companies with dollar revenues and sterling costs that will benefit from a useful FX tailwind.
Of course, the other big effect of sterling weakness is to make those UK-listed companies that may have previously looked attractive to overseas buyers, now look even better value. US corporates for instance, which in a low-growth environment may be struggling to sustain earnings progression, can now acquire consolidation cost and revenue synergies in the UK at the strongest dollar/sterling rate in 31 years (see following chart).
Our list of pre-existing concerns above would suggest caution also towards the oil & gas sector. Here, though, we take a different view, believing that the inevitable near-term decline in supply will more than offset a slowdown in demand growth resulting from weakening global economic growth. The former is a simple consequence of the recent collapse in capital investment in an industry that requires constant heavy investment to counter-balance naturally occurring production decline rates. Economics 101 in its simplest form: a high oil price encourages investment, increases production and supply exceeds demand; the oil price falls and investment dries up, leading in time to prices rising again.
While the situation we find ourselves in post referendum is far from ideal, all is not lost. The UK market prior to the vote had already suffered heavy outflows over a protracted period, leaving it valued at a multi-year low relative to other markets on a series of measures, most notably price-to-book and dividend yield. The decision to leave has inevitably knocked prices further, but the low valuation should help cushion the blow and sterling weakness is a real positive for vast tracts of the market.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.