|2nd Quarter 2016
Euro First 300
In spite of the disruptive influence of the EU referendum the UK stock market was actually the standout performer, in local currency terms, over the quarter. The FT All share advanced 5.2%, boosted by a recovery in commodities, although this masked considerable volatility around the referendum. The decision of the British electorate to leave the EU unsettled markets beyond the UK and in the immediate aftermath there were fluctuations in equity markets worldwide although early losses have since been recouped. Japan’s Nikkei index was laggard in local currency terms over the period as investors questioned the success of the ‘Abenomics’ reform programme in reviving the economy.
The sharp falls in Sterling over the quarter, much of which occurred post the Brexit vote, resulted in significant gains on translation for investors in overseas markets. This was particularly evident in relation to Japan and the US with the Yen and the US dollar are perceived as safe haven currencies in times of volatility. Foreign investors have moved out of Sterling denominated assets on fears of economic slowdown and subsequent interest cuts in the UK. However, the fall in the pound, to a 31 year low of $1.29 at the time of writing, has actually been positive for many constituents of the FTSE 100 for which around 80% of earnings are generated abroad. Not only do their exports become more attractively priced in overseas markets but they also benefit from the translation effect on repatriated profits from subsidiaries in other countries.
In the UK it was the Mid and Small Cap sectors which were hit hardest by the Brexit decision due to their greater exposure to domestically based industries such as Builders and Retailers. Reservations of new houses have fallen and estate agents report cancelled viewings. As mentioned the FTSE 100 is less entwined with the fortunes of the domestic economy but nevertheless among its constituents there was considerable divergence between sectors. While defensive consumer goods companies such as Unilever performed strongly, Financial Services stocks were marked down harshly due to expected loss of ‘Passporting’ arrangements which allowed them to sell into Europe from their UK base. Additionally, for the Banking sector the prospect of lower interest rates threatens a further squeeze on margins.
Precious Metals and Government Bonds were the star performing asset classes as investors perceived them to be lower risk assets. Gold broke through the $1300 level and UK 10 year gilt yields hit an all time low of 0.99%. On the other hand investors sought to reduce UK property exposure leading to some major Commercial Property funds facing redemptions.
Key events of the quarter
The biggest single geopolitical event of the quarter was undoubtedly Brexit. This resulted in political upheaval with the resignation of the Prime Minister, David Cameron, leaving a divided Conservative party seeking a new leader to negotiate new trade deals within and outside of the EU. The immediate economic reaction was a sharp decline in sterling and demand for Government Bonds across the globe. The Bank of England was swift to act and pledge £250 bn of support for the currency in an attempt to reassure investors.
Early in the quarter investors were encouraged by a continued recovery in the oil price which has almost doubled from the $27 low of January. At the time of writing Brent Crude is trading at just over $50 per barrel albeit far from the $115 reached in June 2014. The current demand-supply imbalance is not considered excessive at 1-2 bn bpd (barrels per day) despite Saudi Arabia’s refusal to initiate a production freeze. Supply disruptions in Canada caused by fires and a decline in US inventories also helped address the imbalance while demand from India, China and Russia has grown by 1m bpd in Q1 2016 compared with a year ago.
Beyond the UK the key concerns affecting the global economy have not diminished including China’s ongoing effort to rebalance its economy from an investment-led model to a consumption model while avoiding a hard landing. There remains an ongoing worry about the potential bursting of the Chinese debt bubble and a sharp devaluation of the Yuan. Furthermore, the possibility of a Trump victory in the US presidential election is perceived negatively by investors.
The main economic forecasting bodies have issued downgrades over the quarter. The IMF* has warned that Brexit could cause ‘severe regional and global damage to economic prospects’ and consequently it downgraded its global growth forecasts to 3.3% for 2016 and 3.5% in 2017 (from its April forecast of 3.4% and 3.6% respectively). The World Bank is more bearish, downgrading its Global growth forecast to 2.4% (from 2.9%). However, it still expects 3.6% growth in 2017 led by increased demand for imported goods in Asia.
The OECD** has warned that the world economy is in danger of experiencing a deep downturn if Governments fail to stimulate their economies and suggested that Brexit could have significant costs not just for the UK and Europe but for the rest of the world. The organisation has reduced its forecasts for OECD countries to 1.8% (from 2.2%) for 2016 and 2.1% (from 2.3%) for 2017.
Economic & political trends in world markets
The IMF has not yet revised its UK GDP growth forecasts of 1.9% for 2016 and 2.2% for 2017 which were issued in April. However, in light of the uncertainties generated by the referendum outcome many economists have already trimmed their forecasts to around 1% on average for 2016. In the short term a recession, defined as 2 consecutive quarters of negative growth, looks an increasingly likely occurrence. Obviously, adjustments are tentative at this stage and there is a wide range of possible outcomes.
Economic growth stalled ahead of the referendum and UK GDP growth rate slowed to 0.4% in the first quarter from 0.6% in the previous quarter. Manufacturing output has been subdued for a while partly due to to the sharp downturn in the commodities sector and a slowdown in the wider global economy. The more recent setback in Services was blamed on multi-nationals delaying hiring and investment. This sector is a large part of the UK economy and had been an important driver of growth until recently with consumer facing services performing particularly well. However, consumer confidence has slumped since the Brexit vote, according to a YouGov/CEBR poll.
Chancellor George Osborne has warned that Britain may face tax cuts and cuts to public spending to stabilise public finances but ruled out an emergency Budget. He has already announced plans to cut corporation tax to 15% in an attempt to placate UK and European businesses and abandoned plans to balance the Budget deficit by 2020. Other policy options that may be considered are ‘Helicopter money’ where Central Banks provide loans to governments to boost the economy through fiscal policies such as infrastructure spending or one-off tax cuts. Bank of England Governor Carney has signalled that interest rate cuts or further Quantitative Easing will be undertaken to stimulate the economy if deemed necessary.
The Standard and Poor ratings agency (S&P) along with others has cut the UK’s credit rating to AA with a negative outlook. S&P commented that it believed a recession can be avoided but only if Britain manages to stay in the EU for another 2 years.
The IMF cut its forecast for US growth to 2.2% (from 2.4%) blaming slower global growth, contraction of the energy industry, and a fall in consumer spending. The estimate for 2017 is 2.5%.
The quarter began with the expectation of further rate hikes to prevent asset bubbles developing but gradually the Federal Reserve (Fed) has adopted a more cautious stance. Fed chair Janet Yellen acknowledged upward revision to the rate of GDP growth for the first quarter, but nevertheless painted a downbeat picture of the US economy’s prospects pointing out that low productivity growth, is hampering the longer-term prospects.
US GDP growth was 0.8% in the first quarter of 2016 which albeit well down on the growth rate of the previous quarter due to lower exports and a slowdown in consumer spending. A lengthy period of steadily improving employment data came to an abrupt end with a meagre increase in the key ‘job creation’ figure that was significantly below expectations raising concern over the health of the economy.
The disappointing domestic growth, as well as worries over China, the oil industry and risks associated with Brexit contributed to the Fed confirming it would not raise short term interest rates until greater certainty about the economic outlook has been delivered. Yellen noted that Brexit was a factor behind the decision.
Commentators now expect the next rise to be deferred to September at the earliest. The Fed has held its target range for fed funds at 0.25-0.5% where it has been since December. The paring back of expectations for further rate rises has triggered another rally in Government Bonds. US 10-Year Treasury yields touched 3 year lows as investors speculated that rates will remain lower for longer.
Hillary Clinton is the presumed Democrat nominee in the US Presidential campaign while Donald Trump became the Republican choice.
The IMF forecasts GDP growth for the Eurozone to be 1.5% in 2016 and 1.6% in 2017 (in its April outlook report).
The rate of growth in the Eurozone doubled to 0.6% in the first quarter and the ECB (European Central Bank) edged up its forecasts for growth and inflation for the Eurozone on the back of good corporate earnings and nascent signs of recovery. However, these estimates of 1.6% GDP growth in 2016 and 1.7% in 2017 now look in doubt as the effects of the Brexit vote become clearer. ECB President Draghi has hinted that the Brexit vote could knock 0.5% off European growth over the next 3 years.
European stock markets reacted negatively to Britain’s decision to leave the EU as worries grow that the rise of populist parties in several other countries will lead to further referendums being held. It is feared that the departure of a member of the single currency could signal the possible break up of the EU.
On a positive note, Greece passed legislation on a range of austerity measures, in line with creditor demands. Eurozone finance ministers and the IMF agreed on measures to restructure Greece’s debts when its rescue package ends in 2018.
The IMF expects the economy to grow by 0.5% this year and 0.3% in 2017. The figure for 2017 was upgraded in July from -0.1%, partly due to the government's decision to delay a sales tax hike until the end of the decade.
The main negative for Japan in the second quarter has been the strength of the Yen which has had a serious impact on an economy which depends to a large extent on exports or translation of profits earned overseas. The Bank of Japan held interest rates in June and promises of intervention in the currency markets and an extension of the asset purchase programme when necessary have not yet been materialised. Nevertheless, many analysts expect further easing in monetary policy given that underlying inflation is well below the 2% target.
Japan has suffered from the apparent failure of negative interest rates to stimulate industrial output. Furthermore, the economy also had to contend with the effects of a series of damaging earthquakes. Consequently, Japan’s manufacturing index fell in May to its lowest level since January 2013, standing at 47.6 (below 50 indicates contraction).
Prime Minister Shinzo Abe has held back on a widely-expected fiscal stimulus package, vowing to take “bold” economic steps in the autumn. However, the IMF has warned that labour market reforms are the "only viable option to significantly raise growth prospects" in Japan.
The IMF predicts that overall growth in Emerging Markets will be 4.1% in 2016 followed by 4.6 % in 2017. However, this masks considerable divergence with growth this year estimated at 6.5% for China and 7.5% for India while Russia and Brazil are expected to see declines of -1.8% and -3.8% respectively.
Doubts remain over the trajectory of China’s growth path although data revealed a reassuring annual rate of 6.7% for the first quarter of 2016. This was within the range of estimates with housing and infrastructure countering a slowdown in Financial Services. However, more recent numbers have disappointed with an unexpected fall in manufacturing output and weak factory data for May reviving fears of a slowdown and triggering falls in the stock market. The decision of the Peoples Bank of China’s (POBC) to push the Yuan lower against the dollar was also received negatively.
India made gains as a severe drought in the country seemed to be over and industrial production was boosted by output of both consumer and capital goods. There was some disappointment that the well-respected Reserve Bank of India (RBI) governor is to step down as he is regarded as a key figure in restoring India’s macroeconomic fortunes.
Emerging Markets with large exposure to the commodities sector have seen recovery in their stock markets. Russian equities were buoyed by the rise in the oil price, and a reduction in interest rates as inflation subsided. Latin American had a strong quarter as Brazil’s new President instigated some well received policy changes.
Conclusions and market outlook
Markets were generally unprepared for Brexit and consequently have to deal with a period of economic, financial and political uncertainty. There is currently a lack of clarity over our future relationship with the EU and the timing of our exit although we now know the discussions will be lead by the newly appointed Prime Minister Theresa May.
We discussed ‘what happens next’ in our recent Blog
and concluded that it is apparent that the process of withdrawing from the EU will take considerable time, probably a number of years, especially with regard to formulating new trade arrangements. An acrimonious exit would further prolong the uncertainty and affect the economic outlook both domestically and further afield. The resulting uncertainty for the economy and certain sectors in particular means we can expect a high level of ongoing volatility in Equity markets.
The most likely effect on the UK economy is higher inflation (as import prices rise) and a reduction in growth expectations for the domestic economy as consumer confidence deteriorates. The latter will be affected by the prospect of job losses due to businesses relocating abroad. However, investors have been reassured by the Bank of England’s commitment to provide stimuli in the form of interest rate cuts or a renewed QE (Bond repurchase) programme. The Autumn Budget is also likely to contain measures to promote growth such as fiscal incentives even though this means abandoning the target of eliminating the Budget deficit.
Meanwhile the predominance of companies with an export bias in the FTSE 100 means the implications for the UK equity market may not be as serious as initially feared. Another effect of currency weakness is that it makes UK based businesses look more attractive to overseas buyers so it is quite possible that we may see a pick up in merger and acquisitions activity.
The run-up to the US election could have a meaningful impact on US markets when more is revealed about the candidate’s policies. For the time being investors will focus on when the Fed will increase rates; the Fed minutes for June said rates would be on hold ‘until it understood the repercussions of Brexit’.
In summary, we are likely to see further anxiousness in the months ahead as the UK considers its future outside the EU. However, it is important not to panic and be tempted to sell holdings at low prices. The economy and the stock market are different animals and we should remember that UK companies are in decent shape with far stronger balance sheets than during the financial crisis.
Hence there will always be investment opportunities to be found and experienced active fund managers should be able to identify the best placed companies. They will tilt portfolios towards sectors which should out-perform and avoid those which are underperforming. For example, Neil Woodford has positioned his income fund for low growth, deflation, debt problems, weak productivity and unfavourable demographics yet is confident of making a respectable return.
For the private investor it is particularly important to revisit your long term goals and ensure you have a well diversified portfolio which corresponds to your appetite for risk. Review your chosen funds regularly to confirm that the managers are delivering against objectives and ascertain whether your asset allocation needs rebalancing. For those who prefer not to undertake their own asset allocation decisions a Multi -Asset, Multi -Manager, or Diversified Growth or Income fund may be worth consideration.
* The International Monetary Fund
** Organisation for Economic Cooperation and Development
: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.