26 September 2016

Blog: Brexit Watch - A broad-based rally with just a few unexplained losers

by Kevin Lapwood | 26 September 2016

In the three months since the UK voted to leave the European Union, equity markets have been surprisingly strong. I say “surprisingly”, since little has come out from Whitehall about the process of leaving the EU and, as we all know markets do not usually react well to uncertainty. The politicians have been unusually subdued. We seem to have moved from the strident pronouncement from the new Prime Minister on taking office that “Brexit means Brexit” to a fairly widely-aired view that “Brexit could mean just about anything” and we will not be sure what it means for a long time.

Uncertain times indeed, and yet equity markets have substantially recovered from the initial negative downwards lurch which saw the FTSE100 fall by 5.6% and the FTSE Allshare by 7.3%. Exactly three months on and the FTSE100 is 9.0% higher than it was immediately before the vote, the FTSE Allshare is up by 8.0% and the UK-focussed FTSE250 is 3.4% ahead. Perhaps more surprising is the 12.3% rebound in the FTSE AIM index since the 23rd June. It looks undeniably as if UK markets have shrugged off the potential negative consequences of our leaving Europe that were trumpeted by the Remain campaign in favour of a markedly optimistic outlook.

On the other hand, it could be too early to say. In its August Inflation Report, the Bank of England said that, “developments following the referendum will take time to be revealed in official data. GDP growth of 0.6% in 2016 Q2 was firmer than expected. Many indicators, however, point to much weaker growth in July, with some pointing to a contraction”. The Bank maintained its GDP growth estimates for 2016 at 2% but reduced its estimates for 2017 from 2.3% to 0.8% and for 2018 from 2.3% to 1.8% in 2018.

However, the BoE was clearly worried about the economic impact of Brexit and announced a series of monetary measures to limit the impact. In evidence, it cited The Royal Institution of Chartered Surveyors (RICS) second quarter commercial property market survey that reported a significant weakening in occupier demand following the referendum, and a sharp fall in investor enquiries — particularly from foreign investors. This survey was based on data taken immediately after the referendum. According to the BoE, it was consistent with a further weakening in demand activity in the sector and that was likely to lead to a fall in commercial property prices in the near term. The RICS survey balance of price expectations turned negative in July, and around a third of respondents reported that the market was in the early stages of a downturn, with that share rising to over half for the London region. The BoE also pointed to house price data published for the second quarter by Halifax and Nationwide which showed that the two indices had grown by 1% in 2Q16 having been up by 2% in 1Q16. However, it acknowledged that the first half of the year had been distorted by the pre-announced rise in stamp duty in April 2016. This resulted in some housing transactions that would otherwise have taken place later in the year to be brought forward. The sharp fall in transactions in 2016 Q2 was therefore broadly consistent with expectations, given the surge before April.

Much of the recent optimism in equity markets could be due to the changes in the economic backdrop that the Bank of England measures have caused. In search of economic consequences that are directly attributable to the outcome of the vote, we can point to with certainty are a significant fall in the value of sterling, a 25bp cut in UK base rate and a £70bn increase in the amount BoE funded asset purchases, or quantitive easing, all of which taken singly or in combination could be responsible for a rise in equity markets. Gilt yields fell sharply in response to the rate cut announcement and increased quantitive easing announcement. At one point in August the 10-year gilt yield had fallen by 59% since the referendum to 0.56%. It is currently down 46% at 0.79%.

Generally speaking, the post-referendum equity market rally has been broadly-based with 33 out of 38 industry sector indices now higher than they were immediately prior to the referendum. The main winners were Pharmaceuticals (+23%), Forestry and Paper (+21%) and Building and Materials (+19%).

Not surprisingly, given the focus of attention from the BoE Inflation report, the worse performing sectors since the Referendum have been Real Estate Investment Trusts (-11.3%), Real Estate Investments and Services (-12.1%), General Retailers (-5.3%) and Household Goods and House Builders (-4.4%). What is surprising however, is that along with Fixed Line Telecoms, these were the only sectors to be adversely affected. Despite the catalogue of caution expounded in the Bank of England report, the monetary measures announced in August and prevailing lower exchange rates were regarded as sufficient to overcome the negative impact and potential for lower economic growth in every other sector in the UK market. To say the least, in our view, this stretches credibility.

Since the beginning of August, there has been evidence that the caution around the housing market in July has dissipated. Mortgage approvals were down by 18% in July but total mortgage lending increased by 15% year on year in August to the highest level since August 2007. More recent price data for England and Wales from Rightmove has shown that prices fell by 0.9% in August, by 1.2% in August but rebounded by 0.7% in September as supply shortages began to exert themselves again. There is anecdotal evidence that the lower base rate has resulted in more interest in mortgage products on the supply and demand sides. In the commercial property markets there were some significant fund redemptions in late June and early July and there had already been some evidence of prices becoming under pressure before the referendum, but there has been little sign that the outcome of the vote has exacerbated this trend. Indeed, with the collapse in gilt yields following the recent base rate cut, there is increasing evidence that investors seeking income are about to rely more heavily on property yields.

In our view, the Bank of England report singled out the property and house building sectors for undue attention in the immediate aftermath of the vote which has biased equity markets against those sectors, to the exclusion of every other sector in the market.