It wasn’t supposed to be like this. After the unexpected referendum result, calling for the UK to leave the European Union, the stock market was widely expected to sell off, as political and economic uncertainty increased, with the risk of slower growth or even a recession.
However, after falling for a couple of days, the market rallied sharply. By the end of the second week, day 6 AB (After Brexit), the FTSE 100 was up 4%. So why was this? Was the market so depressed beforehand that the removal or any uncertainty was good news? Did investors take comfort from the fact that David Cameron did not invoke article 50 of the Lisbon Treaty immediately to take the UK out of the EU? Or that George Osborne backed away from an emergency budget to cut spending or raise taxes? The answer to all of these is probably “No”.
There is a far simpler explanation for the behaviour of the stock market. The UK stock market is not the same as the UK economy. The FTSE 100 index is made up of large companies, many of which are multinational or truly global but happen to be listed in the UK. The bulk of FTSE 100 revenues and profits come from overseas, with much of that outside the EU. As such, a domestic slowdown in the UK is not necessarily that important for companies in industries as wide ranging as oil, mining, food, household products, tobacco and pharmaceuticals. Even in financial services companies like HSBC, Standard Chartered and Prudential are heavily dependent upon overseas earnings. Another boost to these companies came from the drop in the pound. Profits earned abroad are worth more to British investors in sterling. This gave a lift to share values.
This overseas earnings effect is clear in the disparity between the performance of the FTSE 100 index of large companies, and the FTSE 250 Index of medium-sized companies. The mid-caps are far more dependent upon the domestic economy and also, on average, more economically sensitive. Since the referendum, the FTSE Mid cap index has underperformed significantly, with a drop of 5% by day 6 AB.
Politicians are calling for a period of calm reflection ahead of choosing a new prime minister and opening negotiations with the EU. In keeping with the mood, I am reflecting on some of the blog posts I have made in the last year, to see how they may be affected by Brexit1. I would be careful in reading too much into the market moves of recent days, much can yet change, but it is nevertheless interesting to consider the implications.
In The Danger of Extrapolation, last September I said it was dangerous to assume that the consistent outperformance of mid-caps against the FTSE 100, over the previous 15 years, would continue into the future. I suggested that large caps could outperform. So far this calendar year, the FTSE 100 is ahead by around 12% on a total return basis, with a similar differential since the date of the blog. It is clearly too early to conclude that the 15 year trend of mid-cap outperformance is over. However, the early moves in favour overseas earnings and more defensive businesses, since the referendum, support the thesis.
A closely related blog, Mega Income Challenge, last August, talked about how some of the largest companies, certain mega-caps, looked particularly attractive. These stocks make up a large part of the FTSE 100 index. In particular, I cited the oil stocks BP and Royal Dutch Shell, the pharmaceuticals company GlaxoSmithKline and the bank HSBC. The oil stocks have had a bumpy ride, especially Shell which took over BG near the bottom of the oil price cycle. But both are now comfortably ahead of their level last August, relative to the index. Glaxo has also been a strong relative performer in that period, and all three stocks have performed well post the referendum.
Only HSBC, of these four stocks, has been disappointing, even though it has outperformed other UK listed banks. An extended period of low interest rates and low growth is not helping the business model, even though the bank remains strategically well positioned and strongly financed. Overall, the Brexit result has been kind to these four companies, and to several other mega-caps. So the early sings for this blog are encouraging.
The third and final blog I am going to review has not worked so well. In What Price Quality? a few weeks ago, I suggested that many high quality, defensive companies were overvalued, including companies like British American Tobacco and Reckitt Benckiser. A combination of greater economic risk post the referendum, and the weakness of sterling benefitting overseas earnings, has led these companies to outperform significantly. Furthermore, lower government bond yields, increases the attraction of dividend yields where investors are confident in the sustainability of those payments.
Owning these types of companies has worked very well in recent days, but the challenge remains about thinking what returns they can deliver into the medium term. Sterling’s devaluation is a one-off benefit, assuming it is sustained. The higher that valuations of quality growth stocks go, the lower the income yield, and the more vulnerable they are to any disappointing trading news. However, this view has clearly not worked in the short term.
It is said that a week is a long time in politics. In the first week since the referendum, we saw the prime minister announce he would step down and the Labour party revolt against their leader. Stock markets have been equally volatile. It will be fascinating to see how markets behave in the weeks and months ahead, but the impact of the referendum result is likely to overshadow many other themes for some time yet.
1. This is no recommendation to buy or sell any particular security