Key market trends to watch as Britain votes to “Leave”

Brexit vote

The British electorate has spoken and the UK has decided to “Leave” the European Union. Whether this leads to Prime Minister David Cameron immediately invoking Article 50 of the Treaty of Lisbon, which is the formal mechanism for any nation wishing to withdraw, is still unclear – not least as the PM has made it clear he is to step down in the autumn.

Such political concerns add an additional dimension to the usual economic and financial considerations which will confront advisers and clients in a post-“Brexit” world.

At the opening today

  • The FTSE 100 plunged by some 9% before rallying to be 4.5% lower by mid-morning. Intriguingly this only served to wipe out the gains made by the UK’s leading benchmark index in the week before the vote, when a series of opinion polls had incorrectly suggested that the “Remain” camp would win the day.

The FTSE 100 has dropped back but is holding the 6,000 level

Source: Thomson Reuters Datastream

  • Sterling dropped like a rock from nearly $1.50 to around $1.35, near 30-year lows, only to bounce to $1.39. The pound also fell from €1.29 to around €1.21 before rallying to €1.2450.

Sterling is very weak against the dollar and euro

Source: Thomson Reuters Datastream

  • Government bonds rallied, as benchmarked by the UK Gilt, whose yield on the ten-year paper shrank to a fresh record low of around 1.08%. Investors also sought out other traditional havens, such as the dollar (which soared against the pound), gold (which rose 4% in early trade to $1,307 after briefly reaching a post-2014 high of $1,337 an ounce) and silver, which popped up to around $18 an ounce before settling at $17.50

The UK 10-year Government bond (Gilt) reached new record lows and investors scrambled for safety

Source: Thomson Reuters Datastream

The fate of the Prime Minister may further muddy the waters but advisers and clients must now decide what to do – if anything – after these initial sharp movements.

Evasive action

The latest Bank of America Merrill Lynch survey of institutional investors notes that the big fund management groups are running their smallest overweight of equities for several years, relatively high cash piles and underweight positions in the UK.

The survey suggests that money managers have already taken evasive action, building up cash positions or perhaps hedging via the futures markets, so they may feel they have already taken sufficient steps to protect investors on the downside.

As a result, one question advisers and clients now need to ponder is whether the drop in the market we have witnessed is viewed by the big funds as a contrarian chance to buy. After all, the valuation paid for an individual security (or index) is the ultimate arbiter of return and the long-term implications of a Brexit are far from clear.

When voting began, the FTSE 100 stood at 6,200, a level where it offers a dividend yield of around 4%. A 10% drop in the index to around 5,600 takes that yield to 4.5% and a 20% drop (which is investment bank UBS’ worst case) takes it to 5%, figures way higher than anything on offer from cash in the bank or sovereign or corporate bonds.

Even allowing for the caveat that the capital risk with stocks is clearly much, much higher, this may tempt some of the big funds to start buying once the dust settles, especially as Gilt prices could rise (and thus yields fall further) in the aftermath.

The FTSE 100 equity yield looks lofty relative to the 10-year Gilt yield

Source: Thomson Reuters Datastream

Sector trends

A quick glance at the biggest risers and fallers in the FTSE 100 after the opening today provides a useful snapshot of market thinking. The table below shows the 10 best performers and the 10 worst.

In simple terms, precious metals miners, dollar earners and defensives are doing best, domestic plays like housebuilders, consumer-exposed stocks and financials the worst.

Precious metal miners, dollar-earners and defensives are doing best post-Brexit, while domestic plays are suffering

London Stock Exchange, Thomson Reuters Datastream. Based on prices at 10:00 on Friday 23 June

The next table performs the same function for the FTSE 350, excluding investment trusts. The picture is very similar – and note that the FTSE 100 is doing far less badly than the mid-cap FTSE 250 and small-cap AIM indices, helped by its greater exposure to exporters, dollar-earners and defensive stocks.

The same trends can be seen across the whole FTSE 350

Source: London Stock Exchange, Thomson Reuters Datastream. Based on prices at 10:00 on Friday 23 June

This ties in with/contradicts trends seen in the run-up to Thursday's vote, when polls that favoured “Remain” saw domestic plays do best and polls that suggested “Leave” would prevail prod gold and silver miners, relatively defensive names and overseas earners towards the top of the leaderboard.

The pound will have a key role to play here, as to whether these trends persist or not.

Any prolonged weakness in sterling following the Brexit vote could help some of the FTSE 100’s individual constituents, as around three-quarters of the index’s aggregate sales come from overseas.

This could act as a further cushion to the index if it really does take a deep tumble in the days and weeks after the “Leave” vote.

A fall in the pound would at least potentially help sectors with big overseas exposure – such as miners and oils – to potentially outperform those with hefty domestic sales, such as house builders and property plays.

The value of overseas earnings will be increased in sterling terms, once they are repatriated to the UK, while fears over an economic hit to the UK and concerns over diminished appetite for UK assets may hit the builders and property developers.

Currency conundrum

Equally, it remains to be seen if sterling would remain depressed for long. Remember that after the 1992 devaluation the pound managed to regain all of the ground it lost against Europe’s currencies within a couple of years, so the benefits of a weak pound could be relatively fleeting.

The pound recovered fairly quickly after the 1992 devaluation

Source: Thomson Reuters Datastream

Besides the housing and property development categories, banks, financial services and asset gatherers could also be sectors that initially find themselves in the firing line.

They are perceived beneficiaries of EU “passporting” rules for the sale of products into the Eurozone and are seen as firms whose income streams may suffer if financial markets remain volatile for a prolonged period.

Continental concerns

One other angle to consider is what happens to European financial markets. A “Brexit” poses huge economic and philosophical questions for the EU.

Britain is the region’s second biggest economy, based on nominal GDP in dollar terms, so the prospect of a trade dispute or erection of additional tariffs could raise concerns over the Eurozone’s already brittle growth profile.

Britain's decision to leave may prompt calls from other discontented political groups, such as the Dutch Party for Freedom, the True Finns and France’s Front Nationale to call for their own votes. Such action would hardly be conducive to breeding faith in Eurozone assets or the euro currency, which could come under greater pressure over the medium term than the UK’s markets and currency.

The EuroStoxx index had been volatile in the run-up to the British vote, with banking stocks and the so-called ‘peripheral’ markets like Italy, Spain and Portugal particularly susceptible to swings in the polls between “Remain” and “Leave.”

A “Leave” vote may put further pressure on the beleaguered benchmark, however the Bank of America Merrill Lynch survey suggests European managers have already built up cash and hedged some of their positions. It will therefore be interesting to see if fund managers use any marked weakness in the EuroStoxx to start buying on the dips or not.

European equities are taking a hammering post the UK’s Brexit vote

Source: Thomson Reuters Datastream

Deus ex machina

The final wild card is whether central banks will enter the fray. Although their power to influence stock prices (and currencies) seems to be on the wane – the phrases “Quantitative Exhaustion” and “Quantitative Failure” are being used more frequently – they are still in the box seat when it comes to bond prices at least.

It is possible that they respond with rate cuts or other monetary tools to try and soothe any market discomfort, although with what degree of success is hard to divine.

It would certainly be unwise of advisers and clients to rely on the central banks – stock markets, inflation and economic growth have lacked real upside momentum for the last couple of years despite the monetary authorities’ best efforts.

And once the dust begins to settle, everyone will again have to start focussing on what really drives securities’ valuations – profits and cash flow growth, which in turn are the result of the broader economic backdrop, as well as the competitive position, financial strength and management skill on offer from individual companies.

It will, frankly, be nice to be able to concentrate on these once more and this is also why retail investors should be very careful about trying to time the market. Market volatility driven by sentiment rather than company fundamentals is normally short-term and people should not panic or get over excited.

In the end it is profit and growth that drives company valuations over the long term and people should not lose sight of that when making decisions about their portfolios.

Recent precedents

A reminder of this is how the UK market performed going into and then coming out of the Scottish independence vote of 2014 and the UK General Election of 2015.

The FTSE 100 did not rally for long after either the Scottish independence vote of 2014 ....

Source: Thomson Reuters Datastream

.... or the UK General Election of 2015

Source: Thomson Reuters Datastream

In 2014, the markets had (rightly or wrongly) feared the economic and particularly political fall-out of a vote for Scottish independence and were volatile heading into the ballot. However, the relief rally did not last long as a crashing fall in commodities prices took a heavy toll on FTSE 100 profit and dividend forecasts and global growth worries crept back in for good measure.

In 2015, the markets had (rightly or wrongly) feared another coalition, or a new Labour Government and were again volatile heading into the vote. The Conservatives won a surprise majority and quickly launched a Budget which stuck to the austerity script preferred by the bond market, but there was little or no relief rally straight after the May vote and the FTSE 100 has subsequently failed to get back to anything like the 7,000 mark.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.