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Market Bulletin - Uncharted waters

27 June 2016

The UK’s referendum result may have unleashed political mayhem, but stock markets have been more measured.

Sometimes even a weekend can be a long time in politics. Since it was confirmed on Friday morning that the UK had voted to end its membership of the European Union, David Cameron has resigned, as has half the shadow cabinet. Nicola Sturgeon has raised the possibility of a second Scottish independence referendum, with the latest polls in Scotland showing 59% in support of a break from the UK. Sinn Fein has called for a vote on Irish union, a suggestion that was immediately rebuffed by the first minister of Northern Ireland. The first minister of Wales has called for the funding formula for Wales to be reviewed.

This is just week one of the UK’s journey to leave the EU, a voyage that may take two years or more. Inevitably, there will be more storms to come in the weeks and months ahead. To borrow from David Cameron’s resignation speech, however, we do not yet know who will “captain” the ship of state. Uncertainties are numerous.

However, we do know that the Bank of England is ready to do “whatever it takes” to ensure orderly markets. We also know that other central banks will support the markets – it is in their interests to do so.

While the leaders of both the Leave and Remain campaigns have kept a low profile since the result was announced, several leaders in the EU publicly expressed the need for the UK to press on with triggering Article 50 of the Lisbon Treaty – the exit clause. David Cameron has left that to his successor, but both Johnson and Gove said there is no particular rush to proceed with the formal process. Angela Merkel struck a conciliatory tone, arguing against punishing the UK. National leaders around the EU called for unity among union members, while there were a few calls for similar referendums elsewhere. Around the world more broadly, the dominant reaction was one of shock and surprise.

“There is much to grapple with at the moment,” said Stuart Mitchell of S. W. Mitchell Capital. “But when it comes to in-out referendums in other European countries, there is not the same parliamentary support.”

The UK has now entered uncharted territory. Assuming a departure process begins this year, it would then not be expected to conclude until 2018, perhaps later, while EU entrances and exits only ever take place on 1 January. It may not be a smooth divorce, as we have been part of the EU for 43 years, but both sides have an interest in getting it right, so as to limit damage to the UK, EU and eurozone. Moreover, whoever is prime minister may need to call a general election first to ensure democratic legitimacy for heading the country’s most important (not to mention extensive) trade negotiation process in decades. The possibility of a new civil service department has been floated.

First to respond

The first market reaction to the news came in the price of sterling, which swung through a range of 13.5% against the dollar over the course of Friday – a broader range than experienced on Black Wednesday in 1992 or during the 2008 crash. The currency reached a 30-year low. Investors have flocked to the perceived safe haven of gilts, and yields have hit fresh lows as a result.

“At times like this, it pays to keep calm when all around are losing control,” says Neil Woodford of Woodford Investment Management. “This doesn’t change anything fundamental. I don’t think the prospects of the businesses we have invested in have deteriorated at all as a result of Brexit. If you accept that the prospects are unaltered and yet prices are lower, then by definition the investment opportunities are more attractive.”

In fact, by the end of the day the response on stock markets appeared relatively muted. There were some sharp initial falls on markets, although in many cases losses simply reflected the fact that they had risen some 5% over the course of the week, due to growing confidence that the UK would vote to remain. Later on Friday, stocks began to climb back. The FTSE 100 ended the week above where it had begun, rising 2%. Even the more domestically-oriented FTSE All-Share finished slightly up over the five-day period, despite suffering a fall of 7.5% on Friday. The FTSEurofirst 300 suffered only slightly more, ending the week down 0.8%. It was driven down on Friday by banking stocks, which suffered heavily after the referendum result was announced. Yet even on Friday, some investors were ready to act.

“Legal & General opened down 15% so we took the opportunity to add to our existing portfolio position,” said Nick Purves of RWC Partners. “Secondly, we recently carried out some research on RBS and concluded that the balance sheet was now much stronger and that the stock represented good value. On Friday morning the price fell back to below the level we first started buying it at and hence we have bought some more.”

The Bank of England was well-prepared for events and Mark Carney promised additional funds of more than £250 billion if needed “to support the functioning of the markets”. Other central banks are similarly determined, offering reassurance to UK and Continental European investors alike, as politics continues to take centre stage. It seems likely that UK interest rates will remain lower for longer, as the priority of the Bank of England will be to protect economic growth.

We may therefore see a weaker currency, more quantitative easing from the central banks, and potentially an uptick in inflation, as the effects of a weaker currency come through in terms of higher prices. Indeed, while some central banks may now hold interest rates at current levels, the Bank of England could yet choose to lower them. Futures markets are already pricing in a 50% chance of a cut to UK interest rates next month. Loomis Sayles wrote in a note on the implications of the referendum that markets are now forecasting that there will be no further rate rises this year at the US Federal Reserve, and that policy at both the ECB and Bank of England should be accommodative.

In the short term, the economy may suffer, and politics is likely to create plenty of headlines. Change may begin to feel like a constant. Nevertheless, Britain still has a healthy long-term economic outlook and, while uncertainty about trade deals will hold back growth in the coming months, once negotiations get going, a cheaper currency will offer a boost to exporters.

“We expect investor nervousness to drive price action which will negatively impact performance this quarter,” said Chris Reid of Majedie Asset Management. “We sold down exposure to the UK domestic market, and increased exposure to companies with a more globally orientated market that, as exporters, would benefit from a weakened sterling. We will look to use our flexible and long-term stock-picking approach, in combination with our liquidity edge, to capitalise on market anomalies.”

Personal implications

George Osborne’s punishing Emergency Budget now appears to be off the table and the Chancellor has since used a press conference in a bid to offer economic reassurance. Some more complicated pensions reforms may be shelved too, as attention turns to trade negotiations, while pension tax relief cuts are possible as the Treasury looks to make savings.

For investors, companies will continue to offer particular opportunities, subject to the usual investment principles of thinking long term and diversifying your assets. There may be times of heightened volatility, and wise company selection will be crucial, not least to take advantage of temporary share price falls. Indeed, some of those opportunities are already emerging.

“We have some cash and are deploying it in selected companies where today’s prices reflect more fear than reason,” said Adrian Frost of Artemis Investment Managers.

 

Artemis, Loomis Sayles, Majedie, RWC Partners, S. W. Mitchell Capital and Woodford Investment Management are fund managers for St. James’s Place.

The information contained is correct as at the date of the article. The information contained does not constitute investment advice and is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.

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