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Uncertain times

03 April 2017

The UK referendum overshadowed a second quarter in which stocks were buoyed by growth, commodities and monetary easing, reports Chief Investment Officer Chris Ralph.

The second quarter offered a salutary reminder to investors that progress is often not only slow, but subject to unexpected turns of events. So it was that after three months of tailwinds, markets were dealt the surprise hand of a British vote to leave the European Union.

The quarter was not without positives, however. Although the IMF shaved its forecast for US growth in June, it was still predicting expansion at a pace of 2.2% for the year – a respectable clip for the world’s leading economy. Growth in the eurozone, meanwhile, stepped up a gear, overtaking that of the UK.

Equity markets continued the rise begun in the final weeks of the first quarter, thanks in part to miners and oil majors enjoying higher prices for some of the major commodities. Indeed, commodities were the outperformer of the quarter and the FTSE 100, that most commodity-sensitive of indices, enjoyed a particularly strong quarter, rising 6.5%. Asian indices were less promising, reflecting slower growth in China and the cost of a rising yen in Japan; in local currency terms, the Nikkei 225 dipped 7.1%, and the Shanghai Composite dropped 2.5%.

The dominant global index, the S&P 500, caught the global mood more accurately than most, rising by a respectable, if unremarkable, 2.3% in local currency terms. There were several factors at play. Firstly, the US earnings recession continued – publication of corporate earnings data1 showed the fourth straight quarter of declining earnings for S&P 500 companies. Secondly, an unemployment report2 published in May showed an unexpected dip in job creation. Thirdly, global trade refused to help – in April the World Trade Organisation forecast that 2016 would mark a sixth consecutive year of below-par growth in international trade, making it the weakest period for trade since the 1980s. Lastly, the possibility – and then reality – of a British vote to leave the EU encouraged risk aversion among investors.

Yet amid the particular troubles of the quarter, the S&P 500 managed to clock up the second-longest bull-run in its history. It was a run that began in 2009 and, as of the second quarter, it had led to the index tripling in value.

Since the financial crisis, markets have got used to relying on activist central banks and the second quarter was no different. The experiment with negative interest rates continued in several currency jurisdictions, notably Japan and the eurozone. Meanwhile, the US Federal Reserve showed no sign of repeating last December’s rate rise, its first in nine years, pointing instead to economic headwinds.

Among the risks it named was the UK referendum. From the vantage point of early July, it remains too soon to assess the true impact of the UK’s vote to leave the EU, but it has already made waves in financial markets. The dominance of the referendum held down stocks in continental Europe; the FTSEurofirst 300 ended the quarter down 1.8% in local currency terms. It was also cited as a risk factor weighing on markets in Asia.

Sovereign bonds saw large inflows across the developed world both before and after the vote. Negative-yielding government debt increased in value by more than $1 trillion in June3 and gilt yields also struck new lows. Ten-year German bunds entered negative yields for the first time in history, while US Treasury yields declined sharply after the result was announced. Inflows reflected both expectations of increased volatility, and a desire to profit from expected central bank largesse.

If there was a lightning rod for financial fallout from the UK referendum vote, it was not risk assets as such but sterling itself. The pound reached a 31-year low against the dollar following the referendum result4, buoying those larger international FTSE 100 stocks for which the translation of their overseas profits into sterling is a positive. But UK companies with a domestic focus were hit hard by concerns about the UK economic outlook and higher costs resulting from sterling’s fall. The FTSE 250 fell 2.9% over the course of the quarter.

The impact of the referendum result was all the greater because markets had expected a vote to remain. Markets will, in time, turn to other worries, but they always dislike uncertainty and investors should anticipate further volatility as the impact of the UK’s vote to leave the EU begins to play out. In such an environment, a long-term focus and a well-diversified approach will be more important than ever.

1 http://www.marketwatch.com/story/earnings-fall-at-fastest-rate-since-the-great-recession-2016-05-26

2 US Labor Department (but FP may prefer UK spelling)

3 Fitch Ratings: https://www.fitchratings.com/site/pressrelease?id=1008156

4 http://uk.reuters.com/article/us-britain-markets-sterling-idUKKCN0ZN1R0

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