Investors fleeing UK equities this year have missed out on healthy gains. Absolute performance in 2016 has been strong with the FTSE All-Share Index showing a positive 8% return. However, this is significantly behind 23% return of the MSCI World Index over this period.
The main talking point regarding the UK equity market over the past few months has, of course, been the impact of the EU referendum. However, prior to the vote there had been a shift in equity market leadership in 2016 compared to 2015. With significant rises seen across oil and materials spot prices, from previously depressed levels, the oil and gas and mining sectors outperformed the broader market by a significant margin over the first half of the year, having had a torrid time in 2015.
Food retailers, another deep value play in the UK market, has also seen a recovery. Aside from these changes, there was also a less pronounced switch away from some areas that had performed well in 2015. Reflecting the above, we have seen a marked change in leadership from a market-cap perspective, with the largest companies in the market, represented by the FTSE 100 Index, outperforming the mid-cap FTSE 250 Index, having lagged for the previous four calendar years.
What About Brexit?
Going into the referendum there was some minor weakness in more cyclical domestic names, but following the announcement of the leave vote markets significantly downgraded stocks with a domestic cyclical or financial bias, reflecting a predicted slowdown in the UK economy as consumers and corporates curtailed spending due to an unclear outlook. Sectors such as retail, banks, travel and leisure were all hit hard, while REITs and property-related companies were also significantly de-rated. Defensive sectors were the beneficiaries, while stocks with overseas rather than domestic earnings also benefited as the falling pound produced upgrades to earnings. Sectors such as pharma and biotech, tobacco and beverages benefited from both effects, while others such as mining and oil and gas producers were beneficiaries of U.S. dollar earnings.
Overall, the managers we have spoken to regard the size of moves and the speed of reaction to have been efficient, although there have been some opportunities lower down the market-cap scale. The FTSE 250, and smaller-cap companies in general, have a greater exposure to domestic earnings, close to 50% for the FTSE 250 Index compared to around 30% for the FTSE All-Share Index, and as a result that part of the market has underperformed since the June 23 referendum to the end of July. There does seem to have been some indiscriminate selling of these areas of the market initially but the subsequent rise in index levels is evidence of these issues working their way through.
Brexit Will Impact Economic Growth
The initial reaction to the Brexit vote is essentially an enhanced version of the consensus view prior to the vote – that the economy is still likely to show a protracted period of low growth – but the level of this growth has been brought into question. Indicators such as the Purchasing Managers’ Index (PMI) and the Consumer Confidence Index have both seen historically significant falls from June to July, while the Bank of England has reduced its GDP forecasts for 2017 and 2018 by 1.5 and 0.5 percentage points to 0.8% and 1.8%, respectively.
In addition, inflation expectations have been raised as the upward push from the weakening of sterling, and consequent increase in import costs, is deemed likely to have a greater impact than the downward pressure from slower economic growth.
We have recently seen a policy response from the BoE in terms of a base rate cut to 0.25% and the announcement of further asset purchases. Despite this initial move there are expectations of further support for the economy being required, including fiscal policy measures from the UK government. The long term nature of the EU exit process suggests that uncertainty will be with us for some time and with this backdrop in mind it is perhaps understandable that we have generally not seen wholesale changes being made to the UK funds that we cover.
How Have Managers Reacted to Brexit?
The overall answer is that there has been limited trading from the majority of UK managers, with very few buying new positions and the majority simply topping and tailing positions based on price moves. This reflects the efficient nature of the market in pricing new information, but also highlights the fact that most managers are waiting for further guidance from company management regarding the outlook for their businesses.
That is clearly going to need the passage of time, and, as a result, managers are sticking to the companies they understand well and those where they have confidence in the long term success of their business strategies – despite the potential for Brexit to push this success further out into the future.
Going into the Brexit vote most managers had portfolios with a domestic, FTSE 250 bias, as they generally did not feel that an exit vote was likely and preferred to hold stocks that reflected their own investment processes and long term views. Combine this with a general underweight to commodities by active managers and it is clear to see why active managers have underperformed passive approaches over 2016. However, over recent years this positioning has usually been beneficial and has contributed to the good relative returns from active managers.
