Monitoring our Winners' performance in June 2016

Monday, 4th July 2016 16:01 - by David Harbage

 The last week of June 2016 is unlikely to be forgotten by investors in a hurry, as financial markets were ‘wrong footed’ by the result of the UK’s referendum vote on continued membership of the European Union - displaying a level of complacency to match the ‘out of touch’ arrogance of many politicians.

Leaving aside the subsequent political turmoil and speculation (impacting the Government’s cabinet, the Labour opposition and Scotland), the economic consequences are set to be very significant for both the UK and the rest of Europe. Rather like Britain’s joining the European Union in 1975 (supported by 66% of the electorate) and the drama surrounding the UK’s exit from the European Exchange Rate Mechanism in September 1992 (after less than two years’ membership), the public’s second vote on EU membership will have far reaching implications. Back in 1975 and 1992, fund managers who were quick to realise how these decisions would affect their universe of prospective investments made exceptional returns.

As in 1992, the prime impact of this most recent political episode has been on the relative worth of Britain’s currency. A quarter of a century ago, we wrestled with double-digit inflation and interest rates of 15% - typically considerably higher than rates applying elsewhere within the Common Market. Nowadays, the 28 EU member countries continue to evidence a wide range of economic indicators and performance – albeit at a much lower overall magnitude of inflation and cost of credit, if not public indebtedness. The table above shows polarised performance between company stocks whose income arises in non-sterling currency and those that are essentially domestic. In particular, multinational big dollar earners dominate the FTSE100 index and amongst our selections, the shares of Unilever rose the most (+17.7%) in June. The equity valuation of other defensive (not economically sensitive) consumer, household goods companies Reckitt Benckiser advanced 11.2%, Imperial Brands (previously known as Imperial Tobacco) 10.2% and medical products business Smith & Nephew +9.7%.

By contrast, domestic stocks were marked lower as commentators predicted economic weakness (as personal consumers and corporates reconsidered spending intentions) and or a sterling devaluation (which, if sufficiently acute, could prompt a hike in interest rates to protect/support the currency). UK-centric banks came under pressure, as did property stocks, builders, airlines and discretionary consumer sectors such as leisure and pubs. easyJet fell 25% in June (and now plan to move their head office to the continent of Europe), Economically dependent Workspace fell 19.5% in the month, closely followed by an 18.9% retreat in the shares of Berkeley Group (whose higher ticket value London apartments have historically appealed to overseas buyers), a 13.3% slide in Premier Inns to Costa coffee group Whitbread and a 10.7% retracement in East Anglian based pub operator Greene King.

Perhaps surprisingly given the outcome, the FTSE100 index enjoyed its best week for more than 5 years post the referendum, and reversed earlier weakness to end the month 5.4% ahead. However, the global nature of its revenue and profit stream (over 70% arises overseas) suggests that a flat spot in the UK economy is unlikely to dominate its progress. By contrast, the more domestically focused FTSE Small Cap index (whose constituents typically expect 70% of turnover and earnings to emanate from the UK) has struggled and delivered negative returns in June – as did the mid cap FTSE250 index, which ‘lost’ 4% of its worth. Ahead of what is likely to be another hectic week for politics – as the Conservatives seek to agree on two nominations for a new leader and the Labour party debate their own future direction - and the financial markets, investors will be asking themselves if the sharp deviation in performance since the 23 June referendum is justified or has been overdone.

The Governor of the Bank of England, Mark Carney’s, remarks late last week indicate that interest rates are likely to be cut: probably to 0.25% later this month or in August, and perhaps to zero% by October. Further easing – and economic stimulus – could arise from Chancellor George Osborne’s earlier intimation that his previous fiscal target (of a budgetary surplus by 2020) had been withdrawn. Unlike the 1992 forced exit from the ERM, the UK’s planned departure from the EU will not take place immediately. A new prime minister, such as leading moderate candidate Theresa May, could yet achieve a successful trade deal with our major European customers – especially if the Brexit result prompts other countries (such as the Netherlands, Denmark and Italy) to press for change in EU policy, via a threat to exit. In the meantime, growth in the UK is set to slow in the second half of this year: domestic GDP could fall to 1% or stall, although any recession is likely to be shallow and short-lived.      

The prime driver of share prices is the outlook for profits over the foreseeable future (looking out, say, to the end of 2017). As yet, while some ‘top down’ economists or market strategists have tried to guess how the UK (and indeed those more widely impacted) might emerge, few industry analysts have assessed and revised their valuations of individual company stocks. In the month of June, consensual forecasts remained largely unaltered but – aided by companies’ own guidance on trading - changes can be expected in July. The writer would expect some of last week’s ‘knee jerk’ reaction to reverse, as investors consider the increasing dispersion of rating across the equity market. For example, the shares of life assurer Aviva appear oversold (no doubt worrying about its ability to passport/sell its UK product into Europe) based on a number of metrics, relative to slow or no growth natural resource stocks - such as BP and Royal Dutch Shell which rose 20% last month, seemingly solely on currency translation hopes.

Over-reactions in stock pricing, exacerbated by emotive forces, are inevitable at times such as these – providing opportunity to astute investors who have the courage to back their own convictions. There will be no shortage of speculation about how the political landscape will shape up or how certain aspects of the domestic economy (such as the London housing market) might fare over the next two years or so, but almost certainly the more extreme negative outcomes are least likely and history often shows that a reasonable ‘muddle through’ path emerges. Besides having a view and confidence in the business models of individual companies (or the merit and risk-reward profile of other asset types), investors should remain alert to the value (or lack of it) on offer by reference to a particular equity investment. In times of heightened uncertainty, many will naturally become more risk-averse and favour Value – rather than seek Growth – evidenced by factors such as balance sheet strength and dividend growth. A belief that the UK economy can remain relatively resilient over the medium term persuades this investor to retain exposure to domestic industry segments (such as national, lower-priced, volume-focused house builders), rather than seek comfort in defensive business activities or commodity-dependant mega caps which now appear fully valued.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.