Independent Pilots Financial Services is part of the Benchmark Capital Group, backed by FTSE 100 company Schroders. Our investment committee often draws upon Schroders vast resources. This piece is written by one of their investment writers.
It’s been three years since the UK voted to leave the EU. We look at what’s happened to the economy and markets, and what’s next for investors.
On 23 June 2016, the UK public voted on whether or not to stay in the European Union (EU). Many expected the UK to remain in the EU, but by a majority of 52% to 48% the Leave campaign won.
The UK was scheduled to leave the EU at 23:00 UK time on 29 March 2019. However, after the UK parliament failed to approve the Withdrawal Agreement, it was granted an extension with a new deadline set for 31 October 2019.
Below is a timeline of crucial dates along the road to Brexit and six charts showing how the UK economy and financial markets have fared over the past three years.
Azad Zangana, Senior European Economist and Strategist said while the UK economy has remained relatively stable through a turbulent period, real risks remain on the horizon.
“UK economic growth bounced back at the start of 2019 but still remains sluggish. Having slowed markedly in the final quarter of 2018 the UK economy grew 0.5% for the first three months of 2019.
“Growth was helped by stockpiling ahead of the initial Brexit deadline on fears that a no deal could dry up imports, which also led to the biggest quarterly trade deficit since at least 1992.
“But whether the disruption hits or not, a build-up of inventories will lead to de-stocking at some point. This is likely to cause the economy to slow.
“The resignation of Prime Minister Theresa May has raised the risk of a no-deal Brexit. If the bookmakers’ favourite, the former foreign secretary and mayor of London Boris Johnson, becomes the new prime minister, then the hard-line Brexiteer could take the UK out of the EU without a deal.
“If this were to happen, we would anticipate the economy to slow and fall into recession around the turn of the year. While the Bank of England would probably cut interest rates eventually, the expected depreciation in the pound would cause inflation to spike. The household sector has already run down its safety buffer in the form of its savings rate, therefore a contraction in demand is very likely.”
Arguably the biggest barometer of Brexit is the value of the British pound. Since the vote to leave it has fallen more than 14% against the US dollar and 13% against the euro.
The strength or weakness of a currency is linked to the health of its country’s economy and the stability of if its government.
What’s happened in markets since Brexit?
FTSE vs sterling
While the weakness in the pound has made traveling abroad more expensive for those who earn their money in pounds, it has provided a boost for UK stocks.
More than two thirds (70%) of the revenues of the companies listed on the FTSE All-Share index are generated overseas. When the profits from those revenues are converted from a strengthening currency back into sterling they are worth more.
The chart below shows how closely the fortunes of UK stocks have correlated with the fall (and sometimes rise) of the pound against the US dollar.
Read more: How currencies move stock markets
In the immediate aftermath of the referendum the FTSE 100 and the FTSE 250 fell 9% and 12%, respectively. But since the close of the market on 23 June 2016, UK shares, as measured by the FTSE All-Share, have risen 28.1% as of 15 June 2019.
The relatively stable global economic backdrop has been helpful. Global investors have bought into the so-called Goldilocks scenario; a “not too hot, not too cold” combination of stable growth, benign inflation and low interest rates.
Support for the UK market and the economy came from the Bank of England (BoE), which has kept monetary policy loose, ensuring businesses and markets have access to funding.
However, the UK stock market has lagged global stocks. Since the Brexit vote, China shares have returned 42.1%, according to Thomson Reuters data; US stocks returned 41.6% and world stocks have returned 32.7%.
UK stocks have returned 28.1%, marginally outperforming emerging market and Japanese shares which returned 27.3% and 26.8% respectively. European stocks returned 17.5%.
Of course, there are lots of other factors that have influenced UK and other markets during this period. The global nature of UK equities has led to international developments setting the tone for the market, and this continued to be the case since the EU referendum.
Some of the key international drivers over the past three years have included monetary policy decisions by the world’s major central banks, global economic activity and, more latterly, US-China trade tensions.
Domestic vs international earners
Although the UK stock market has held up relatively well, there has been a contrast between domestic companies which earn most of their revenue outside the UK versus those that earn most of their revenues internationally.
As the chart below illustrates, in the period from mid-2013 through to the end of 2015, the UK economy outperformed the global economy, sterling was strong and UK domestic companies outperformed UK overseas earners. Then, as Brexit fears set in and the UK voted to leave the EU, UK domestics significantly underperformed. Exchange rates were a major driver of this, as the market discounted the beneficial translational impact of weaker sterling for companies with significant overseas earnings. However, it was also in large part due to UK domestic companies suffering a “de-rating” amid fears the UK economy would grow at a lower rate going forward outside the EU..
Investors have indiscriminately shunned UK stocks as a consequence of Brexit, and the market overall has suffered a de-rating. Prior to the EU referendum, investors had been prepared to pay approximately 15x the UK stock market’s expected aggregate earnings for the year ahead. Today, this multiple, or “rating” is around 13x, which compares very favourably to the global stock market, trading on approximately 15x expected 2018 aggregate earnings.
UK stocks unloved and valuation at 30-year lows
The negativity of international investors towards UK equities is entrenched – global fund managers have been “underweight” the UK for three years, according to Bank of America Merrill Lynch’s global fund manager survey. Investors are said to be underweight an asset class when they are allocating less capital to it than would normally be the case.
Valuations reflect the degree to which investors have shunned UK equities. The chart below tracks the UK market’s valuation discount versus global equities based on the average of three metrics. The metrics used are:
- Price-to-book value (PBV) ratio – The ratio used to compare a company’s share price with its book value (the book value is the actual value of the company assets minus its liabilities).
- Price-to-earnings (PE) – A ratio used to value a company’s shares. It is calculated by dividing the current market price by the earnings per share.
- Price-to-dividends (PD) ratios – A ratio that shows how much a company pays out in dividends each year relative to its share price.
All valuation metrics have their strengths and weaknesses, so combining three reduces the risk of distortions.
Sue Noffke, Head of UK Equities, said near-term issues persist whilst Brexit remains unresolved but UK shares provide plenty of opportunities.
“Based on this analysis, UK equities are trading at a 30% valuation discount to global peers, close to their 30-year lows. While it is likely to persist until there is some form of clarity over the terms of any Brexit deal, the valuation gap provides an attractive entry point for investors with long time horizons.
“If we do experience a recession in the near term, we would expect it to be local to the UK (possibly the result of a disorderly Brexit) rather than a global one, although we are in the latter stages of the economic cycle. This gives us a degree of comfort that the UK equity market’s yield (currently around 4.5%) is sustainable as the large majority of UK stock market dividends derive from overseas.
“As stock pickers we see plenty of opportunities within the UK – across all parts of the market, large as well as small and mid-sized companies – which could help build portfolios capable of generating superior long-term returns.”
Investments concentrated in a limited number of geographical regions can be subjected to large changes in value which may adversely impact the performance of the fund.
Equity [company] prices fluctuate daily, based on many factors including general, economic, industry or company news.
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