One thing that has always fascinated me during my 20 years watching
the market has been its capacity to surprise. Perhaps it is this factor that
maintains the appetite and intrigue of investors and traders, hungry to
exploit price weakness and differentials in search of opportunities and
I (along with most investment managers in the country) was genuinely
dumbfounded that Brexit has indeed become a reality. There is little point
now questioning the result – it is done. The country has to accept it and be
only unified in attitude that a better, stronger Britain can result outside of
the Brussels club. I do believe it is fair to say that it will take time and there
will be pain (in some quarters) that presents en route. Negotiations with our
European neighbours have already commenced and securing trade deals
will be top of the list. I (like all) will assume (hope is a better word) these
discussions will result in favourable terms. And that will be just the start.
The market duly reacted negatively on Friday 24th June; I understand some
hedge funds have been wiped out on the back of the aggressive downside
initially experienced. Having rallied significantly into the vote, the stage had
been set for large price falls in the event of a Brexit materialising. The
sectors most vulnerable to the economic risk and uncertainty now upon us
have predictably taken a pasting. Here I refer to Banks and Property
companies primarily but airlines have also been hammered with retailers
close behind. Swift profit alerts have already been issued from both IAG
and Easyjet and this has made for sobering viewing for many (including me).
Notwithstanding the heavy downside seen in some sectors, others
having rallied strongly which has been a hugely pleasant surprise. The
net effect of these movements has resulted in the FTSE 100 index
currently residing higher now than it was pre Brexit which is incredible if
believable. Large cap companies that earn high proportions of their
profits in dollars have risen as a result of the weakened pound.
Pharmaceutical and oil companies predominantly should see beneficial
effects to earnings due to this foreign exchange translation (assuming of
course these FX rates prevail going forward). Diversified equity portfolios
have thus performed resiliently through what has been flagged up to be
a potentially disastrous outcome by many. However one needs to
understand that around 70% of the profits earned by FTSE 100
companies come from overseas which has actually revealed the FTSE 100
holistically to be somewhat of a Brexit hedge. Larger downside has been
seen in the more UK centric mid cap FTSE 250 space which is currently
down 7.7% on the pre vote level. Remember, today’s frenzied levels are
exactly that and markets could look a whole lot different tomorrow.
There are obviously other macroeconomic forces at work beyond our
current selfish fixation with Brexit which continue to pose risk for
investors. Attention should not be turned away (for example) from
consideration of the health of the US and Chinese economies.
Brexit is not (yet at least) a Lehman Brothers event nor is it global as the
2008/9 systemic credit crisis was. Yes there are now significant risks to the
UK economy as evidenced by the credit rating downgrades the AAA UK
has just been dealt. And yes there are genuine concerns for the European
economy at large as a result of Britain leaving. These realities cannot be
denied and that is why swift trade agreements are needed to be put in
place to steady this ship and allow for some confidence to materialise.
Stock specific comment
Contrarian stockpickers will undoubtedly now be unsurprisingly weighing up
the risk reward potential of the banking and property sectors in particular.
Simultaneously brokers and analysts will be pondering whether the ‘dollar
earners’ are in profit taking territory. I have been reducing in this recently
outperforming space. Regarding oil majors, I note the oil price itself is still
struggling to punch through the $50 per barrel level, yet the sector has
significantly short term outperformed discounting of course the current FX
situation. I am not convinced in the second half of this year that oil will
progress definitively higher and thus see opportunities here to at least
reduce overweight positions. While both Shell (2010p) and BP (420p) will
work hard to find ways to maintain their current dividend payout ratios,
there is little doubt to me that the oil price will assist matters. Thus these
companies will be forced to cut out more cost probably at the expense of
future production cashflows. I am wary. In a similar vein, I would be looking
to reduce into current strength GSK (1540p), the pharmaceutical giant as the
PE ratio (valuation) once again looks toppy to me at 17 times next year’s
profits. While I appreciate the cable (pound/dollar) exchange rate may
remain favourable for the foreseeable future, the recent uplift is difficult to
ignore. Certainly any reversal in current FX trends would see shares lower.
Housebuilding stocks have borne the brunt of the recent and current
market weakness. The sector was already riding high on price to asset value
metrics and Brexit has been the catalyst for a brutal correction. Demand
concerns weigh as does bank mortgage finance risk. The plus is that a
weaker pound allows foreign buyers to get more bang for their buck
which is a counterbalancer. Not for widow or orphans, dividend yields are
likely maintainable. But this is a sector only for higher risk aware clients. The
same goes for banks where the outlook has become unclear at least. It is fair
to say a base rate rise is now unlikely any time soon.
Incredible times to be investing in markets and I have no doubt the next
few months will bring further volatility and opportunity.