As UK equity fund managers come to terms with the Brexit vote, David Stevenson looks at what shape their portfolios were in and what’s next for this asset class.
In the time leading up the UK referendum result on June 24, to say that UK equities were volatile is a gross understatement. The Brexit campaign blurred the lines between politics and finance and with every political development, there was a financial reaction.
For instance, the murder of Labour member of parliament Jo Cox on June 16 was seen as beneficial to the ‘Remain’ campaign, amid reports that her attacker shouted “Britain first!” as he killed her. (In court, the defendant gave his name as “Death to traitors, freedom for Britain”.) This aided riskier assets such as equities and specifically homebuilders and banks, as the tragedy made a Brexit seem highly unlikely.
But a week later, the result came in. Britain is to leave the EU. It caught almost everyone off guard, from the already tainted pollsters, whose reputation had been tarnished after last year’s general election, to the once seemingly infallible bookies, who usually price things right.
Most importantly, it caught out the markets, which had priced in a Remain victory. “The market acted according to the script. Banks, homebuilders and travel stocks sold off,” says Alper Ince, managing director and sector specialist at alternative asset manager Paamco.
This script seems to have been written some time before the result was known. Colin Morton, head of two UK equity funds at Franklin Templeton Investments, predicted in advance that should ‘Leave’ win, the homebuilding and real estate sectors would be hit first and sterling would fall sharply.
And so it panned out. Following the vote, the biggest losses were recorded by mortgage specialist bank Shawbrook Group, whose shares fell 23.3%, and estate agent Foxtons, down 22.22%. Next-worst hit was Virgin Money, losing 21.47% of its value, and budget airline easyJet at 18.36%. Shares in Barclays and Royal Bank of Scotland were temporarily suspended from trading after falling 10.3% and 15% respectively.
Phil Harris, manager of the UK Equity Growth fund at EdenTree, speaking ahead of the result and with Barclays and Lloyds in his portfolio, said: “We’re hedged whatever happens, we’ve got a good set of companies. It’s not a catastrophe whether we vote in or out.” Harris saw the event as “a short-term storm” and an opportunity to add selectively to stocks. “Clearly it impacts the UK equity market. We’ve seen a rollercoaster ride as the polls have swung round,” he said.
Julien Jarmoszko, European equities analyst at S&P Global Market Intelligence, was surprised by some of the share price falls, especially among large-cap Continental firms with little to no exposure to the UK market. He says that Dutch telecoms firm KPN was down 10% on the day of the result, despite having no exposure to UK GDP. French telecoms firm Orange, which has a 4% stake in BT, also fell.
CURRENCY TO THE RESCUE
One of the hallmarks of recent times has been the currency war phenomenon, in which countries introduce measures to ensure their currency falls in value to boost their export markets. The ploy has been successful for Japan and it could be argued that China has used similar tactics, albeit perhaps unwittingly.
The collapse in the value of sterling to a 31-year low against the US dollar has boosted the FTSE 100, which after some initial shockwaves was rallying at the time of writing. The index contains international companies who collectively derive about 70% of their revenue from outside of the UK and benefit from a cheaper pound.
The biggest winners were large energy players, such as Shell and BP, as well as pharma stocks such as GlakoSmithKline and AstraZeneca.
Sharp falls in sterling do have a precedent, though. In 1990, the UK entered the European Exchange Rate Mechanism but was forced out two years later as sterling tanked, ultimately leading to a boost in exports.
However, currency works both ways and European investors into UK stocks will be facing losses. Although this is mainly a UK crisis, it has obvious implications not only for Europe but the rest of the world. The use of currency hedging, a feature of investing last year when quantitative easing started in Europe, might come to the fore again as investors seek to protect against fluctuations in currency valuations.
It’s been reported that Mark Carney, governor of the Bank of England, is going to loosen monetary policy, a 180-degree turn from the end of last year when interest rate hikes were expected. Howard Archer, chief economist at economic think-tank IHS Global Insight, says that while a reduction in rates is likely, he doubts that the UK’s central bank will bring rates down to zero or into negative territory as “the hit to bank profitability could perversely reduce credit availability”.
Another option open to Carney is to start a programme of asset purchasing again, similar to 2012. While this has had limited success in achieving European Central Bank chief Mario Draghi’s aim of increasing inflation, it is an option that many think Carney will be forced to take. However, Carney has stated that there is only so much the Bank can do and he has put the onus on politicians to formulate a strategy quickly that will allow the economy to reach its full potential.
The reaction of Europe to the result has surprised some, including S&P’s Jarmoszko. He thought that there would be little appetite from Europe to open negotiations and the UK would take the lead. At the time of writing, the UK’s Conservative government and the opposition Labour Party are in complete disarray. Meanwhile, despite their own elections next year, it seems Germany and France are eager to stem any possibility of contagion by showing the UK the cost of leaving the EU. German chancellor Angela Merkel has already scuppered some of the Leave campaigners’ hopes by saying the UK cannot cherry-pick which freedoms it wants: if it wants access to the single market, it must also allow free movement of people.
It is the fear of being left out of the single market that is the biggest threat to financial services, including UK-based asset managers. If the UK is no longer able to passport its services across Europe, it could cause problems for the UK economy, which is the world’s fifth-largest mainly due its financial services. HSBC has confirmed that it is not going to move its headquarters from London, so, according to Philippe Bodereau, global head of financial research at Pimco, the impact on international investment banks just concerns operational disruptions with limited macroeconomic significance.
As for asset managers, a chief executive of one of the UK’s largest houses recently said that following a Brexit, they would just work from the firm’s Luxembourg office, changing it to the firm’s HQ.
But Jarmoszko does not think that fund centres such as Paris and Luxembourg will appreciate such ‘brass-plate’ operations. In his words, they would take a “dim view of one guy turning on the lights in Luxembourg and claiming it to be their headquarters”.
“People are worried about EU dissolving,” says Paamco’s Ince. “That’s when you see real stress in the system, then you see volatility levels spike up.” The market does not want a repeat of the 2011 debt crisis when it entered into a full risk-off mode, although for some, this type of market provides opportunities.
Jarmoszko says he’s trying to highlight to his clients those stocks with big price falls that are unwarranted. “It’s the time you can buy some quality companies, even exposed to the UK, which are available at the same price or multiple as 2011,” he says.
Others are less sure that the sell-off is over and are therefore more hesitant. Ince thinks it’s too early for buying as markets usually take time to digest and discount what this type of event means. “There’s too much uncertainty as to how the political landscape is going to evolve,” he says.
Some take the view that the Brexit issue, while certainly more important than last year’s drama with Greece, pales in comparison to other macroeconomic events. In the US, not only has the Federal Reserve backtracked on its normalisation policy of raising interest rates, but in November the presidential election will take place, causing market ructions whoever ends up in the White House. Markets tend to favour an economically conservative Republican, and there’s usually a brief market rally after such a candidate wins. But with Donald Trump running for office, these rules will probably not follow, given the ‘unique’ style of his campaign.
At the same time, there are those who think it unwise to play down the importance of Brexit. Dean Tenerelli, European equity portfolio manager at T Rowe Price, says: “There will be a protracted period of uncertainty, not only in UK and European financial markets, but also globally. Markets do not like uncertainty.”
Others maintain that the economic shock of Brexit will be limited to the UK and reject the idea it could start a global recession. Paul Jackson, head of multi-asset at Source, says: “If you think about it in pure hard numbers, the UK is less that 4% of global GDP.”
He adds that the UK’s loss is another nation’s gain – for instance, if a car manufacturer decides not to build a plant in the UK, it will likely choose an EU member state and thereby reduce the risk of a global recession. While it is perhaps a tad unfair to describe Brexit as a sideshow until the real business of global economics starts again – China’s susceptibility to a ‘hard landing’, for instance – this vote was very much a UK issue. The UK exports more than 40% of its goods to the EU, while Germany exports about 6% of its goods to the UK, so the idea that any raising of tariffs would lead to a stalemate seems a bit fanciful.
As for how UK equity funds are going to handle the market going forward, it is perhaps telling that Franklin Templeton reduced the annual management charge on three of its top UK equity funds late last month from 75 basis points to 45 basis points. The firm made no mention of Brexit and, looking at the top FTSE 100 holdings contained in its Rising Dividend Fund, there’s no reason to think the fund itself is suffering. Post-Brexit, it could be that UK equity funds do not have any pulling power for international investors. US investors have been underweight the asset class for some time and unless you’re currency hedged, any gains will be eaten away by forex rates.
The UK has decided to go it alone, against the advice of major powers and organisations such as the OECD. But with a rallying FTSE 100, bolstered by cheap exports in other sectors, as one commentator has it, “Maybe we can come out of this without too many scars.”
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