UK equities: divergence and recovery
The FTSE 100 index has outperformed the FTSE 250 since the EU referendum. In this Q&A, Trevor Green explores the reasons why – and assesses the longer-term prospects for UK equities.
The UK’s surprise vote to leave the European Union at the referendum on June 23 had an immediate and sizable impact on the financial markets. The FTSE 100 index dropped eight per cent on the morning of June 24 before rallying slightly to close three per cent down on the day before.
The FTSE 250 fared worse, falling seven per cent on June 24. By the close of trading on June 27, the FTSE 250 had dropped 14 per cent – its biggest two-day loss since the fallout from the ‘Black Monday’ crash of October 1987.
These sharp falls reflected fears about the UK economy as its future relationship with the EU, its major trading partner, was cast into doubt. Manufacturing and services sectors contracted sharply in July, according to purchasing managers’ index (PMI) figures, prompting fears of a looming recession.
The FTSE 100 stabilised relatively quickly, however, and by June 29 it had returned to pre-Brexit levels. The index is comprised mostly of large international firms that derive much of their revenue from overseas and stand to benefit from the collapse in the value of sterling, which fell to a 30-year low against the dollar following the Brexit vote. The FTSE 250, which tracks smaller companies that are more exposed to the UK economy, took longer to recover.
Nevertheless, both indices are now trading well above pre-Brexit levels, although the FTSE 100 continues to outperform the 250. As of August 12, the FTSE 100 was up eight per cent since June 23, while the FTSE 250 had seen a two per cent increase. The speedy appointment of Theresa May as prime minister following David Cameron’s resignation and the Bank of England’s pro-active ‘Super Thursday’ monetary stimulus package on August 4 have helped to quell market jitters.
Questions remain, however. Is the strong performance of the FTSE indices sustainable, given the lingering uncertainties over the terms of Britain’s exit from the EU? Will the fall in sterling prompt a wave of opportunistic acquisitions? And which sectors remain vulnerable to an economic slowdown? In this Q&A, Trevor Green, Head of UK Equities at Aviva Investors, explores how Brexit is affecting UK equities.
How would you account for the divergence in the performance of the FTSE 100 and FTSE 250 after the referendum?
The biggest change in the immediate aftermath was the depreciation of sterling against the dollar. The FTSE 100 has a large exposure to the dollar, because it includes global businesses in industries such as beverages, tobacco and pharmaceuticals. The fall in the value of the pound gave an immediate fillip to those dollar earners – even if their fundamental strengths remained unchanged.
The FTSE 250 is more domestically-focused, with less global exposure. It was hit more severely in the immediate aftermath of the referendum result, as fears spread that there would be consumer-spending paralysis and a decline in long-term investment in the UK. When uncertainty spreads, investors tend to favour large, liquid and diversified businesses such as those in the FTSE 100 index.
However, the FTSE 250 has recovered as these fears have eased in the weeks following the vote. A survey from Visa UK, published on August 8, showed British consumer spending rose in July, for example, confounding expectations.
Will the political context shape the dynamic between the FTSE 100 and the FTSE 250 going forward?
Political uncertainty was a major factor in the market volatility following the vote, but the appointment of Theresa May as prime minister has helped bring calm. It’s possible that Phillip Hammond, the new chancellor, will introduce incentives to help the housing market in his Autumn Statement, which would be welcome, as a strong housing market helps foster secondary investment and wider market confidence.
Looking further forward, investors will keep a close eye on the ongoing Brexit negotiations. Any sign that the UK may not retain its access to the single market is likely to hurt market sentiment, especially in those parts of the financial sector that rely on providing services to EU clients. If that happens, risk-averse investors are likely to again favour the FTSE 100 over the 250.
Has Brexit exposed weaknesses among British companies?
When external events hit markets, companies that had enjoyed good momentum before the event are usually the ones that emerge the quickest, while weaker companies take longer to recover. That will be the case in the UK after the referendum. While weaker companies may be tempted to blame their problems on Brexit, the referendum result is likely to have exacerbated existing issues rather than created new ones.
This is the moment for CEOs of UK companies to stand up and be decisive, and to be proactive about addressing sector-specific challenges. For investors, it will be important to focus on the underlying fundamental strengths of companies. As a house, we are overweight long-term mid-cap names in sectors such as support services and media – even though some companies have seen their share prices fall after Brexit – because we’re optimistic about their longer-term prospects.
In July, Japan’s Softbank’s acquired UK smartphone-chip designer Arm for £24.3 billion and AMC Entertainment, a Chinese-owned US cinema chain, bought Odeon and UCI cinemas for £921 million. Do you expect further M&A activity in the months ahead?
The decline in sterling has made UK companies more attractive for foreign investors and share prices of companies in the FTSE 100 and 250 have risen as rumours of further takeovers spread. The collapse in the exchange rate has opened up a window of opportunity, especially if you take the view that the British economy will recover after the initial short-term impact of Brexit.
What’s your view? How do you expect the UK economy to perform over the coming months?
First the bad news: We expect there will be a technical recession before the end of the year. Certain sectors would look somewhat more vulnerable than others in that event. Momentum in the commercial property market was already turning after years of growth, and the additional negative impact Brexit will have on the share prices of property companies may not become evident until the fourth quarter. Retailers have suffered because the fall in the value of the pound has made imports more expensive. We have focused our investment into companies we believe are exposed to areas that are seeing structural growth and those we expect to be relatively resilient if consumer spending slows.
What’s the good news?
The Bank of England has moved decisively to cut rates, which shows it is prepared to support the economy. Moreover, most of the reasons companies choose to do business in the UK – the stable legal and regulatory environment, for example – remain in place. Soon after the referendum, Wells Fargo announced that its new European headquarters will be in London. Shareholders voted in favour of the merger between the Deutsche Bourse and the London Stock Exchange in July. Large pharmaceutical companies such as GlaxoSmithKline and AstraZeneca have talked about increasing investment in the UK. This illustrates that Britain is still seen as a good place to do business; that hasn’t changed overnight.
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