Market Comment 08/09/2016
Market Commentary - September 2016
During the three month period to the end of August, Sterling fell sharply following the surprise ‘Leave’ result in the UK’s European Union referendum. As a result, for the UK based investor, all major asset classes performed strongly.
Generally, UK listed companies with significant overseas earnings made good gains and this enabled the FTSE All-Share Index to return 9.0% over the period. The collapse in Sterling meant overseas holdings became relatively more valuable and the FTSE World Ex UK Index returned 15.8% in sterling terms. To give a scale to the weakness of Sterling, the same index returned just 3.0% in local currency terms.
Japanese equities performed poorly in local currency terms (MSCI Japan Index, -2.8%), but a flow of funds into the Japanese Yen, on so called ‘safe haven’ buying translated this loss into a 15.9% gain for the UK based investor. Currency moves against Sterling observed during the quarter have been extraordinary.
Demand for gilts was strong and the FTSE Gilts All Stocks Index returned 10.6%, significantly outperforming more risky high yield corporate debt which returned just 5.2%. If an investor bought the 10 year gilt at the end of the period and held it to maturity the yield on their investment will be 0.64% per annum.
The Brent crude oil price fell 5.3% to US$47.0 per barrel during the quarter, as inventories remained high and evidence emerged that some US onshore producers were looking to increase production following the bounce in the oil price from the January lows.
The gold price benefited from the demand for ‘safe haven’ assets, rising 7.7% to $1309/oz by the end of the three month period. This translated into a 19% gain in Sterling terms.
The collapse in Sterling meant overseas holdings became relatively more valuable and the FTSE World Ex UK Index returned 15.8% in Sterling terms.
The implications of the surprise ‘Leave’ result in the EU referendum continues to reverberate around the markets. Sterling has fallen sharply and the 10 year gilt yield has moved well below 1% per annum. The kneejerk response has seen a collapse in the share prices of UK listed companies which are domestically focussed and economically sensitive (such as housebuilders, banks, non-food retailers and travel companies). The ‘Leave’ campaign’s assertion that there will be no economic disruption from a ‘Leave’ vote is about to be tested.
Investors are pricing in a poor outcome for the UK economy over the coming years as they are concerned that the following scenario may play out.
- A weaker currency imports inflation making goods ‘on the shelf’ and also holidays and petrol more expensive to buy, thus diminishing purchasing power.
- Listed retailers tend to purchase a lot of their goods overseas and sell them in Sterling. Retailers’ margins, therefore, come under pressure from the weaker currency, whilst demand may suffer as consumers have less disposable income to spend.
- Despite the weaker currency making the UK a more competitive place to manufacture goods for export, foreign direct investment is curtailed due to uncertainty over future access to the single market. This impacts employment and therefore consumer confidence.
- Diminished consumer confidence and headlines trumpeting an acceleration of house price declines in London (as employees in global financial service companies, buy to let and international investors shy away from the market) undermines house prices nationally.
- In such an environment, banks make it more difficult for borrowers to access mortgages and loans, although interest rates remain lower for longer.
- Whilst occupational demand and supply for commercial real estate in London is tight currently, the demand side of the equation softens thus reducing build activity and the upward pressure on rents. The cycle turns, leading to reduced demand from investors and lower prices.
- The government’s tax take undershoots forecasts whilst the demands on social payments rise, thus exacerbating an already large budget deficit. This demands a budgetary response from government.
The ‘Leave’ campaign’s assertion that there will be no economic disruption from a ‘Leave’ vote is about to be tested.
Should the the above transpire, there is an appreciable chance that public opinion will swing against the result before a deal to leave the European Union is concluded, particularly as the British Union is now threatened and our ability to solve the migrant issue by ‘going it alone’ is far from clear. For these reasons, an exit from the European Union remains far from being the ‘done deal’ which investors are currently implying, and, in any case, will take a substantial amount of time to enact if taken to fruition.
We, therefore, believe that the moves in the share prices of many domestically focussed, economically sensitive companies immediately post the Referendum result were overdone and we have been actively topping up those holdings where we believe there is a strong case that the market has over-reacted to the Referendum news.
The Spanish general election which was held immediately after the UK’s EU referendum saw an unexpected shift towards an incumbent ‘pro-European’ political party and has been widely perceived as a ‘stability first’ response from the Spanish electorate to the UK Brexit referendum result. It remains to be seen whether this move to support the status quo will be evidenced in forthcoming elections across the European Union. If it is, then the impact of ‘Brexit’ to global economic growth should be low and investors will take heart.
However, we have been and remain focussed on areas where we think the biggest risks to global economic growth could emanate, namely the US and Chinese economies.
The bank credit cycle in the United States has turned and it is becoming more expensive for companies to raise debt. This, ordinarily, should be taken as a warning sign that the headwinds to further equity market performance are getting stronger. However, central bankers around the world are standing at the ready to provide the necessary liquidity in order to try to mitigate Brexit risk impacts, should they materialise, and this should be supportive to asset prices in the short term.
However, we are increasingly hearing evidence (from UK listed companies with operations in America) that wage pressures are building in the United States. There is a risk that, at some stage in the future, investors come to the abrupt conclusion that US interest rates have to rise swiftly and unexpectedly to counteract inflationary pressures. Whilst not our central scenario, this outcome would have a detrimental impact on share prices and should not be ruled out.
...central bankers around the world are standing at the ready to provide the necessary liquidity in order to try to mitigate Brexit risk impacts, should they materialise, and this should be supportive to asset prices in the short term.
China has managed to avoid a significant slowdown in her economy this year by injecting huge amounts of debt into the economy during the first few months of the year via state owned enterprises in order to boost investment. Whilst a short term fillip, little has been done to address the economy’s structural weaknesses and it is, as yet, uncertain how long the Chinese authorities can continue to paper over the cracks that are appearing in the economy.
We, therefore, remain cautious.
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Issued and approved by Cornelian Asset Managers Limited (CAML). You should remember that the value of investments and the income derived therefrom may fall as well as rise and you may not get back the amount that you invest. Past performance is not a guide to future returns. This material is directed only at persons in the UK and is not an offer or invitation to buy or sell securities. Opinions expressed represent the views of CAML at the time of preparation. They are subject to change and should not be interpreted as investment advice. CAML and connected companies, clients, directors, employees and other associates, may have a position in any security, or related financial instrument, issued by a company or organisation mentioned in this document.
Chief Investment Officer