Post-Brexit rebound in UK stocks comes with a red flag

Markets in difficult position as economic fallout remains unclear
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Anyone looking for clarity about the state of post-Brexit vote Britain has been left to untangle mixed messages on newsstands this week, as recent economic activity in the UK is hailed as proof of both a “Brexit bounce”, “Brexit boom” and a “Brexit tremor”, depending where you look.

As financial markets approach the relatively quiet trading month of August, investors appear equally equivocal about the country’s prospects, in spite of this week’s surprise rebound in the FTSE 250 stock index — seen as a barometer of domestic UK companies — to pre-referendum levels.

Tempting as it is to read the FTSE 250’s rise as proof that all is well, Garfield Kiff, UK fund manager at M&G, cautions that the advance hides a less positive story.

“Put simply, despite the steady aggregate numbers, the stock market has concluded the UK is heading for a sharp economic slowdown,” he says.

The revival of the FTSE 250 looks like a vote of confidence for UK plc, but within the index there has been a clear divergence between the outperformers, which have been largely overseas earners, and domestic businesses such as housebuilders, retailers, and challenger banks.

“The recovery is not a vote of confidence in the prospects of the UK economy as, much like the FTSE 100, the international and somewhat esoteric make-up of the 250 disguises some sharply divergent share-price performances,” he argues.

The FTSE 250’s ability to shrug off the 14 per cent plunge triggered by last month’s shock referendum result also goes hand in hand with persistent weakness in sterling and record low UK government bond yields.

UK-listed companies that earn revenues outside the country, and comprise about half of the index, have been buoyed by the fact that sterling remains almost 12 per cent lower against the US dollar than it was before votes were counted. This also explains why the FTSE 250 may be close to pre-Brexit levels in its domestic currency, but in dollar terms remains 11.6 per cent lower.

The pound’s weakness is why Mike Bell, global market strategist at JPMorgan Asset Management, is concentrating on larger, international-facing companies in the UK’s blue-chip index in spite of the mid-cap rally.

“We expect that large-cap UK stocks will outperform the FTSE 250 going forward, driven partly by our expectation of further sterling weakness,” he says.

But the picture in the UK is not entirely downbeat. Contrary to expectations, a number of domestic-focused companies have posted positive results in recent weeks, including Just Eat, Europe’s largest takeaway website. These, along with the UK’s better-than-expected 0.6 per cent growth in the second quarter, have contributed to the equity market bounce.

The problem, says Larry Hatheway, chief economist at asset managers GAM, is that both the GDP data and recent corporate results are based largely on the period before the referendum.

“The vote came right at the tail-end of the second quarter of the year,” he points out. “So these figures reflect conditions before it happened — and at a time when no one thought it would happen. We won’t see the real impact until we have the Q3 numbers.”

Data for the weeks after the UK’s vote to leave are limited, but what has appeared has been worrying — including a “flash” survey of business activity in the manufacturing and services sector that signalled a downturn in the economy.

Official figures showing labour, construction and manufacturing conditions will not be released until mid-September, but the full economic landscape will not be clear until the end of October, when GDP figures for July, August and September are published.

Until then, fund managers in UK mid-cap stocks are focusing on the Bank of England’s next policy meeting.

Markets are convinced that the BoE is poised to cut interest rates from 0.5 per cent next week to cushion the economy from the impact of the vote and bond yields are falling in response — leaving 10-year gilts trading at an all-time low of 0.71 per cent.

“Are the Brexit worries over? No, I wouldn’t say so, not while the full effects are unknown,” says Mark Martin, head of UK equities at fund manager Neptune.

“But the UK’s central bank is poised to act to cut rates and the country has a floating currency which both help — so there is some bargain hunting going on. We still don’t know what the true repercussions are.”

There is one further reason why markets may seem relaxed: the possibility that the UK’s separation from the EU will not take the form many of its supporters wanted.

If, as seems possible, the split is slow to occur and results in a “Brexit lite” arrangement in which the UK is able to access the single market in exchange for accepting free movement of goods and people — not too dissimilar to current arrangements — financial markets would consider this the most positive, least disruptive outcome.

“Add to that the fact we’re had the promise of fiscal austerity easing and investors are expecting an interest-rate cut next week before we’ve seen data that shows what effect Brexit has had,” says Nick Nelson, head of European equity strategy at UBS. “That’s why at the moment, it feels as if there is more good news than bad.”

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