Market Bulletin (04/07/2016)
The direction of travel last week seemed ever downward. British politics has not appeared so unstable – or its politicians so duplicitous – for decades. Forecasts for the economic outlook now tend to the negative. The European Banking Authority is readying itself to move out of London, to be followed by staff from a number of financial houses, and Dublin, Frankfurt and Paris are already rolling out PR campaigns that target the biggest banks. Sterling has fallen by more than 10% against the dollar from where it was on the night of the referendum.
Yet markets were singing from a different hymn sheet. The FTSE 100 rose 6.9% to register its best week since 2011 and its highest level since August last year. The more domestically-focused FTSE 250 remains significantly below where it was prior to the referendum result, despite rising over the course of last week. The FTSEurofirst 300 rose by 3.5% over the five-day period, the S&P 500 by 3.2%, and the Nikkei 225 by 4.9%. Lloyds even felt confident enough to make a fresh bond sale to US investors on Thursday.
One reason London markets have held up well thus far is that so many international companies choose London as their place of listing. That creates an obvious disjunction between the UK economic outlook and the FTSE 100 – an index dominated by a handful of global giants, among them Royal Dutch Shell, Unilever and HSBC. Indeed, 40% of FTSE 100 companies declare their dividends in US dollars. Since the UK accounts for just 4% of global GDP, UK economic problems exert a negligible impact on their share price.
If the FTSE 100 is a global bellwether, the FTSE 250 is more closely allied to the British economy. When the UK economy outperforms the global economy, then the FTSE 250 tends to outperform the FTSE 100. But in 2016, a year so far dominated by the referendum, it has fallen more than 5%.
“The smaller, domestically-oriented companies that make up the FTSE 250 are better positioned to benefit from the recovery and growth environment we’ve seen since the financial crisis, which explains the significant outperformance,” said Nick Purves of RWC Partners. “However, in less certain times the bigger companies offer the greater protection, underlining the importance of maintaining a diversified approach to UK equities.”
Past performance is not indicative of future performance.
Investors with a portfolio that is well-diversified, not just within the UK but across different global markets and asset classes, will have weathered the recent storm relatively well. Diversification remains the right investment strategy as uncertain times loom.
One particular concern in the run-up to the vote and its aftermath has been the outlook for investment in the UK. Goldman Sachs includes 25 stocks in its FTSE 250 “investment-sensitive” basket. Those shares have fallen by more than 20% this year, and most of the dip came after the announcement of the referendum result. For exporters boosted by a falling pound, however, the outlook is very different. A JP Morgan basket of 25 export-heavy FTSE 250 companies has gained more than 10% this year, most of it in the past ten days. In short, simply owning an index is not enough – investors also need to understand how its component companies will be affected by Britain’s vote to leave the EU.
In fact, a UK exit is not yet a rock-solid certainty, as John Kerry, US Secretary of State, intimated last week. Although expected, it could yet be derailed by a general election, disputes over the legality or legitimacy of an exit, and the possible need to agree an ‘exit deal’ nationally before formalising it.
“We think there is a 25% probability the UK does not actually exit,” said Hamish Douglass of Magellan. “It is not a binding referendum and at the end of the day they have been asked a very simplistic question. Scotland and Ireland are probably going to launch a constitutional challenge. If [that fails], they may put up referendums to leave the UK. Westminster could then say ‘this wasn’t the question we asked the people.’”
Calling the tune
As politics descended into puerility last week, it took a Canadian to raise the tone. Ignoring ongoing attacks by Leave campaigners, Mark Carney, governor of the Bank of England, struck a serious and measured note on Thursday as he warned that the UK was facing a downturn. In response, he promised a further round of monetary stimulus and “probably some monetary easing”.
“There is no doubt that the banking system he is presiding over is as healthy today as I can ever remember it, with unlimited liquidity available and capital at levels that are a multiple of what the banks carried into the far more tumultuous events of the global financial crisis – this will certainly have helped calm the market,” said Mark Holman, CEO of TwentyFour Asset Management. “At the moment the market is pricing a 33% chance of a cut on July 14th, and a 70% chance by year end.”
Following Carney’s speech, short-term gilt yields turned negative for the first time in their history. UK equities are now yielding four times more than ten-year government bonds – an unprecedented development that underlines one of the fundamental attractions of investing in equities.
Amid all the market movements, there is consensus that the next two years or so are unlikely to be comfortable for the UK’s economy. On Friday last week, the Chancellor annulled his former plans to reach a budget surplus by 2020 – he has since announced plans for ambitious cuts to corporation tax. In a report published since the referendum result, Credit Suisse wrote that the UK’s expected exit was “the most significant pull back to-date from the post-World War II consensus of closer integration and open trade. Such a significant secular shift has the potential to have substantial negative implications for growth, corporate profits and asset prices in the medium term.” Carney’s own comments reflected this downbeat view.
“One uncomfortable truth is that there are limits to what the Bank of England can do,” he said. “In particular, monetary policy cannot immediately or fully offset the economic implications of a large, negative shock.”
Expectations that the Federal Reserve will raise rates later this year have fallen since the referendum result was announced. The European Central Bank appeared to be continuing with business as usual since the result was announced, although its chief economist warned last week that the result could detract from growth in the eurozone economy.
“We expected such an outcome to change the landscape for global monetary policy,” Loomis Sayles said in a note published last week. “This includes a higher probability of further joint fiscal and monetary stimulus in both Japan and the eurozone. The market is now pricing an unchanged Fed Funds rate for over a year’s time, and modest easing is expected at the Bank of England and ECB. We are nevertheless both hopeful and expect that market conditions and economic growth will warrant more Fed tightening than this benign path.”
It seems savers should prepare for the next move in interest rates to be down not up, and for rates to therefore remain lower for longer. Despite the short-term uncertainties, those saving and investing for their future need to avoid being distracted from that longer-term focus.
Magellan, RWC Partners, Loomis Sayles and TwentyFour Asset Management are fund managers for St. James’s Place.
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