Market Review 1st July

Markets and key events
All eyes have been focused on the aftermath of the UK’s Brexit vote this week as investors have scrambled to try and understand the potential implications for the global economy. As previous post, the week had been broken into 2 parts: the 4 days running up to the referendum and the 1 day after it. Somewhat surprisingly given the result, this week has proven to be the mirror opposite. On Monday, most equity markets continued the selloff that had begun on the previous Friday, with those markets at the epicentre hardest hit. By the close, UK mid cap stocks, which are more exposed to the UK domestic economy, were down 13.7% from their closing level prior to the referendum result with European equities not far behind, falling 9.3% as the particularly high weighting within the market towards financial stocks took its toll. Sterling continued to fall, touching a fresh three-decade low against the US dollar, whilst safe haven government bond assets continued to rally, along with the Yen, the dollar and gold. However, early signs of bargain hunting surfaced in Japanese equities as investors began to factor in central bank intervention and this hinted at what was to follow.

By Tuesday, markets had a calmer tone and a small rally in sterling, perceived as the primary escape valve for Brexit concerns, led to a return of risk appetite which has continued and even accelerated over the rest of the week. This is very different from most people’s expectations and certainly a long way from the ‘meltdown’ scenario predicted by many backing a Remain vote. Therefore, whilst it is still very early days, we have been examining what has caused this unexpected turn of events. Our best assessment is that, after many months of investors demanding fiscal policy action to fight deflation as the effectiveness of Quantitative Easing (QE) has increasingly been called into question, but with no clarity over what would finally jolt politicians into action, investors are of the opinion that Brexit is the catalyst that was needed. It is an almost universally held opinion around the world amongst economists, central bankers and organisations like the IMF that Brexit is bad for global growth in the short term, which is why so many people were concerned about the effect on asset prices, and risk assets in particular, if the vote was for Leave. However, whilst markets went down the predicted path for 2 days, they appear to have decided that ‘bad is the new good’ and that risks to the downside are now finally great enough for governments to act.

The evidence to back up this view has come thick and fast, starting on Tuesday when the South Korean Government announced a $17bn fiscal stimulus package, citing growth concerns in the second half of the year due to the potential impact of Brexit. This was followed on Wednesday by Mark Carney, Governor of the Bank of England, laying out clearly that monetary easing over the summer was highly likely and that he did not rule out further QE. However, in a strong hint to politicians in the UK that was very much in line with those given by Marion Draghi in recent months, he cautioned that the tools available to the bank were probably not sufficient to prevent the UK from slipping into a recession at some point in 2017. This was acknowledged the very next day by Theresa May, the UK’s Home Secretary and contender for the leadership of the Conservative Party and, therefore, the position of Prime Minister, who said that she would abandon the current Chancellor’s commitment to run a fiscal surplus by the end of the current Parliament, with the Chancellor himself, George Osborne, doing the same just this morning. The net result of the above has been a strong rally in equity markets, a scenario that was largely unforeseeable in the event of a vote for Brexit. The FTSE All Share has risen 5.8% to lunch time Friday (London time) and, whilst that is after a sharp drop last Friday, the market is still at the highest level it has seen this year. It must be acknowledged that the performance of different parts of the market has diverged dramatically, although not unexpectedly. The FTSE 100 has risen over 9% on the week, as the large cap stocks of which it is made up receive approximately 75% of their earnings from overseas and, therefore, benefit from the translation of overseas earnings into a much weakened sterling. By contrast, the FTSE 250, which consists of UK mid cap stocks where the overseas earnings figure is less than 50%, are down circa 7% as we write on fears over the domestic UK economy. Alongside the UK, other markets have enjoyed strong returns as well, with Japan the next biggest riser at 4.9%, whilst the Euro Stoxx 50, S&P 500 and Hang Seng rose 3.8%, 3.0% and 2.6% respectively. In spite of this rally in risk assets, nerves were arguably still on display as government bond yields fell to fresh record lows, with 10 year Japanese government bonds hitting minus 0.23%, 10 year Gilts hitting yet another record low and 2 year UK Gilts dipping into negative territory this morning for the first time ever. However, whilst there will undoubtedly be investors who are buying such safe haven assets because they still feel nervous about the longer term impact of Brexit, some of the buying may be in response to reduced expectations of a US rate rise.

‘Et tu Brute?’
When David Cameron took the leadership of the Conservative Party in the UK he promised to unite the party and stop its members “banging on about Europe”, an issue that had divided them for many years. The referendum was a political gamble that it was hoped would put the issue to bed for good and provide clarity and certainty going forward. However, the victory for the Leave campaign has done the exact opposite, as the various permutations of what life outside the EU could look like are now debated. The job of delivering a Brexit negotiation that will be seen as a success in the eyes of the UK electorate will be challenging, as free movement of labour is a key pillar of the freedoms demanded by the EU for access to the single market but an end to it would appear to be one of the key demands of the UK voting population. Unfortunately, by losing the referendum and making his own position untenable, David Cameron has created a political vacuum at the very worst moment. One thing that has become clear is that not only did the Leave camp have no agreed position on what the UK outside the EU should look like after a vote for Brexit, they did not even have an agreed position on what the Conservative Party should look like. The past few days have been likened to the political drama House of Cards or even Game of Thrones where “…you win or you die. There is no middle ground”. The ‘betrayal’ of Boris Johnson, the charismatic ‘poster child’ of the Leave campaign and the bookmakers’ favourite to lead the Conservatives, by his supposed chief ally, Michael Gove, was Shakespearean in its brutality but has thrown the whole campaign wide open. However, what is clear is that, in spite of demands from Europe, there will be no triggering of Article 50 until the UK Government has a new leader and a degree of stability is restored. How long that will take is hard to know but it could certainly be into next year and 6 months is a long time in politics so at this stage nothing is off the table. In such turmoil, this provides the slimmest glimmer of hope for those in the Remain camp that a way may yet be found to negate the result. However, much of the economic damage could occur in the coming months if companies choose to relocate to the continent to end the uncertainty so our best guess is that this is a done deal, even if the timing and details are not.

Whilst currency has been an important component to performance for some time, this week was more extreme than for a long time and it became the single over-riding factor. It is possible that these movements will unwind within a short period of time but, for now, it has caused disparity of returns across the portfolios in the very short term. 

As you can imagine, we are having daily conversations about what is happening in the market and almost every possible scenario has been considered, although we did not see Michael Gove’s move coming! Whilst markets are in positive mood as the weekends, there remains a huge amount of uncertainty around what Brexit really means for the global economy, UK and European politics and markets in general. At the moment, markets seem to be taking the lack of clarity around what the UK does to exit the EU and when it will trigger Article 50 as an excuse to ignore it and are behaving as if it will not necessarily happen. However, it seems likely that it will and we wonder if it will be at the point that Article 50 is enacted that we see concerns resurface and perhaps the sell off in risk assets that we would have expected to see already. As we have said earlier, with such a trigger being possibly many months away, we believe that we will not have clarity on the full implications for some time and, whilst investors cannot afford to wait until the final trade terms are known, as that will be many years, we see no reason act hastily.