Although economic data and the stock market have proven surprisingly robust since the UK voted to leave the European Union last June, the outlook is more complex than the figures suggest, as James Balfour explains.
The decline in sterling since the referendum on EU membership on 23 June has been a key driver in the strong performance of the UK stock market. Sterling declined by 18.3 per cent against the dollar between 23 June 2016 and 11th January 2017[i]. Over the same period, the FTSE 100 index rose by 14.8 per cent, reflecting the huge boost companies will gain from overseas earnings as they are converted back into sterling.[ii]
Moreover, mining companies, which account for a large proportion of the index, have gained from the higher price of base metals and other commodities, which are priced in dollars. The price of commodities, as measured by the Bloomberg Commodities Index, rose by 13.7 per cent during the course of 2016[iii].
Economic data since the Brexit vote last June has been much better than many analysts predicted while UK stocks have also soared in value. What conclusions can be drawn from these trends?
I don’t think you can attribute the rise in the FTSE100 to any fundamental improvement in the outlook for companies or the UK economy following Brexit. The vast majority of the move can be explained by the currency’s depreciation and a premium being placed on US dollar earnings which are deemed safer than those emanating from the euro-zone.
Turning to the economic data, it may be some time before we see the impact of the Brexit vote on the economy. It may take a while for consumers to adjust their behaviour, for example, as the higher cost of imported goods erodes their purchasing power. Meanwhile, the strong growth in manufacturing output, which unexpectedly hit a two-and-a-half-year high in December[iv], might also be misleading.
The data could simply reflect the fact companies are making the most of their goods being cheaper abroad as a result of the currency depreciation. We have yet to see the official economic data for the fourth quarter. This could be quite strong, simply reflecting consumers upping their spending before price rises come into effect. If the trend of the weaker currency continues there will be global opportunities for manufacturers, though the negotiations on Brexit may hamper long-term deals into the EU.
Given the Brexit process will not be formally triggered until the end of March, are we simply experiencing the proverbial `calm before the storm’?
Markets seem to be ignoring any bad news at the moment. They fell back and rallied after the Brexit vote and repeated that pattern when Trump was elected. But I certainly don’t think it's going to be plain sailing. The currency is absorbing much of the shock at the moment, and is perhaps an indicator that further economic turbulence lies ahead.
Wages are growing at a sluggish pace; rising by an annual pace of just 1.7 per cent in the third quarter of 2016[v]. Meanwhile, although overall inflation remains low - the Consumer Price Inflation Index increased by just 1.2 per cent in the year to November[vi] - the cost of some goods and service is rising sharply. Inflationary pressures will mount this year as the increased cost of imported goods feeds through to the High Street. Petrol costs have risen sharply: the price of a litre of petrol increased by nearly 13 per cent over the course of 2016.
So consumers are already feeling the pinch in some areas and the squeeze is likely to intensify in the year ahead. That is where the impact of Brexit could be felt most keenly[vii]. This could lead to further divergence in the performance of large stocks exposed to overseas earnings and those focused on the domestic market.
We also do not yet know what sort of deal the UK is looking for. Will London, for example, seek continued access to the Single Market? It is difficult to forecast the outlook for the economy and the stock market until we know these details.
What can investors do to protect themselves from any fallout that accompanies the triggering of Article 50?
The best approach is to remain invested in companies with strong and stable business models for the long-term. A short-term fluctuation is less of a concern if you are invested over a three or five-year horizon. Investors have already taken cover in traditional safe havens such as miners and oil companies. However, there could be opportunities in consumer staples following the sell-off that took place after the rise in US interest rates, given that the sector should deliver stable earnings growth whatever the economic background.
Many of the factors that drove the FTSE 100’s outperformance in 2016 remain relevant. The FTSE 100’s defensive profile and the large proportion of overseas earners could underpin its position as a relative safe haven should investors’ nerves fray when Article 50 is served.
On a related theme, which sectors do you think could perform best in 2017?
UK industrial companies should do quite well. Admittedly, their valuations are already high, but they should benefit if US growth increases. They could also benefit from a current pick-up in European economic growth. Meanwhile, the oil sector should do well as long as the OPEC deal on production cuts remains in place. However investors will have to be selective, rather than blindly buying any stock with oil exposure, if they are to pick the winners.
It’s probably wise to adopt a cautious approach to the consumer discretionary sector given the uncertain outlook for real incomes this year. Investors are clearly nervous about the sector, with the share price of Next and other clothing retailers coming under severe downward pressure after Next recently cuts its earnings forecast after a poor Christmas. Next has said Britons are spending less on clothes; preferring to use spare cash on holidays, eating out and events. The company also expects further pressure on spending as inflation rises[viii].
The retail sector is also facing the heady cocktail of rising business rates and the structural shift from brick and mortars to online shopping. Famous names such as BHS and Austin Reed disappeared last year, while high profile names like Marks and Spencer, Banana Republic and American Apparel announced retrenchment programmes. Sadly, further casualties are likely in 2017.
How do you think dividends will fare this year?
I am more hopeful now than I was at the start of 2016, when there were fears over the mining and the oil and gas sector and various other high-dividend yielding stocks. The outlook now appears more stable with dividends in oil and gas, for example, better covered following the rally in the oil price. Companies such as Shell that are seeking to sell assets are more likely to be able to realise the prices they are seeking.
The mining companies have already cut dividends to a low level, in hindsight, the cuts may have been premature, but taking a positive view, this means that payouts have rebased to more sustainable levels. Indeed, the best day to buy mining stocks last year was the day on which they announced dividend cuts. The recovery in the price of commodities has left some mining companies enjoying relatively large cash inflows, which will allow them potentially to pay special dividends.
Companies with US dollar exposure have also benefited from the sharp fall in the value of sterling. This has boosted their earnings in sterling terms and their ability to pay sterling-denominated dividends.
Overall, there is certainly less risk that we will see dividend cuts in 2017 than there was at the beginning of 2016. The uncertainty associated with Brexit and the election of Donald Trump may even boost dividend payouts. Companies could delay investing in the UK or postpone a decision on whether to invest in a facility in Mexico or the US until the outlook become clearer. That is going to leave more cash available to be distributed in dividends.
Have any sectors or companies been unfairly punished or rewarded following the Brexit vote?
The financials sector has been one of the best-performing areas of the market since Brexit. Few would have expected that outcome prior to the vote given that financials could suffer if the UK no longer has access to the Single Market or to the passporting regime that enables asset managers and other financial services companies to easily sell services across the European Union. The sector has benefited from the recent rise in US interest rates and the expectation of further hikes this year. Much improved capital ratios are also reducing the risk of further regulation to improve the health of the banks’ balance sheets.
Even so, I think the rally may have gone too far in terms of the banks at least. It may be justified as far as asset managers are concerned, given that the rise in the price of financial assets will boost their earnings.
By contrast, some of the consumer companies have come under unjustifiable downward pressure. Investors may have taken the view that even though companies continue to report good earnings figures it is best to sell now. That may be correct in some cases but is not the case for companies with sound business models that sell goods that are likely to remain in demand.
By contrast, the utilities sector may have been undersold. They could face higher interest rates on their borrowings if interest rates rise. But it is important to be aware of those companies that benefit from inflation-related payments, so that even if inflation and interest rates do rise they will be well placed to maintain revenues.
Do you expect merger and acquisition activity to pick up this year?
M&A activity in the UK totalled £144.5 billion in 2016, down sharply from the record £321.5 billion reached in 2015 but in line with the five-year trend, according to Thomson Reuters[ix]. The outlook for 2017 is difficult to forecast. Valuations in the UK are undoubtedly attractive to overseas buyers given sterling’s fall. However, US companies may be keen to repatriate cash if Trump slashes corporate taxes as promised. That would mean they would be less likely to use cash to acquire UK-based businesses. Currently, American companies are holding $2.5 trillion overseas. Cash brought home is taxed at 35 percent, the US having the world's highest corporate tax rate[x]. Much will depend on how quickly Trump cuts taxes.
Another headwind is coming out of China, where the government is cracking down on outflows. That means two of the main buyers of UK companies in recent years, China and the US, are constrained.
However, there could be an increase in intra-UK transactions, while European businesses could increase M&A activity in the UK depending on how Brexit develops. Sterling’s weakness is a clear tailwind. 21st Century Fox’s agreement to pay £11.7 billion for the 61 per cent stake in Sky that it does not already own had been long expected, but the slump in the pound may well have speeded up the process[xi].
Overall, however, the increased uncertainty suggests the risks involved in M&A are elevated. Bolt-on M&A deals, which simply expand a company’s presence in a sector where it is already operates, will probably continue but deals that fundamentally change a business are less likely.
[i] Bloomberg, 11 January 2017 https://www.bloomberg.com/quote/GBPUSD:CUR
[ii] Bloomberg, 11 January 2017 https://www.bloomberg.com/quote/UKX:IND
[iii] Bloomberg, 11 January 2017 https://www.bloomberg.com/quote/BCOMTR:IND
[iv] Reuters, 3 January 2017 http://uk.reuters.com/article/uk-britain-economy-pmi-idUKKBN14N0MM
[v] Index of UK labour costs per hour, experimental: July to Sept 2016, Office for National Statistics, December 2016
[vi] UK Consumer Price Inflation, November 2016
[viii] Reuters, 4 January 2017
[ix]Reuters, 30 December 2016
[x] CNBC, 20 September 2016
[xi] BBC News, 15 December 2016 http://www.bbc.co.uk/news/business-38326530
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