7 April 2016
Perfect storm or perfect opportunity?
by Frank O’Nomics
A number of fears have been hanging over financial markets in the first quarter of this year; worries about the world economic outlook and a sharp pick-up in market volatility have been key elements, but the one that seems to be preoccupying traders in the UK the most is that surrounding the EU referendum. In a survey of 104 banks and investment companies conducted by the CBI and PWC, only 14% were more optimistic about the outlook for this year than last, with 35% pessimistic, showing the first drop in business sentiment for 4 years. Given that financial services account for approaching 10% of the UK economy, this matters. Political events and financial uncertainty from Europe and China are behind this sentiment shift and present what Rain Newton-Smith, director of economics at the CBI has described as a “perfect storm”. But is that really the case? The survey itself notes that UK company profits are healthy, hiring is steady (unemployment continues to fall) and business volumes are growing. If this is the case even with the uncertain global backdrop, the key will be whether concerns about a vote to leave Europe will really make any difference, and the evidence from market movements would suggest that, on balance, it wont. Extending this argument further, any sell-off on Brexit fears should present a good opportunity to buy some of the major asset classes.
Consider the performance of FTSE so far this year. The first two months were as challenging as many can remember, but the recovery in markets means that FTSE is down just 1.5% year-to-date. All markets may have recovered, but the modest fall in FTSE compares with the French market (CAC) which is down over 6.5%, the German DAX down almost 9% and the Spanish market down nearly10%. This hardly suggests that Brexit fears are hanging over UK equities, with the lack of growth much more a function of the poor performance of mining stocks on global economic slowdown concerns.
It is also worth looking at the performance of sterling. The acceleration of Brexit worries when Boris Johnson sided with the vote leave camp pushed the £/$ exchange rate to its lowest for 7 years, but such levels have prompted some support, with cable already some 5cts off its lows for the year, down just 2.5%. The move against the Euro has been more pronounced, with sterling over 6% lower this year, but this is coming from a relatively strong position which means that the pound is close to the middle of its 5 year trading range against the Euro.
Finally, if we look at bond yields we can see that there has been very little impact. 30 year gilt yields are virtually unchanged both year-to-date and over the last 12 months, at close to a very historically low level of 2.28%, a level that has not been under-mined by foreign investors selling £9 billion of gilts since the start of the year, according to figures from the Bank of England. This hardly suggests that the bond markets have any real concerns about Brexit (a point recently highlighted by John Redwood) implying little prospect of higher inflation resulting from a lower currency, or any increase in the budget deficit (and hence the supply of government debt) prompted by slower growth.
Regardless of the performance of the various asset classes, the bigger concern may be the reduction in business activity and investment, and there are some clear signs that, at the very least, many companies are delaying investment decisions until after the 23rd June. Within the surveys it seems that concerns were greatest in the banking sector, where sentiment fell at its fastest level since the extremes of the financial crisis in 2008. Banks have worries that go beyond Brexit, particularly since the introduction of negative interest rates in Europe and Japan (which penalises commercial banks for holding excess reserves at central banks). Bankers are understandably frustrated by the postponement of deals, some of which they have worked on for quite some time, that have been put hold for the next three months. Deloittes have reported that the value of domestic M&A deals is currently running at about half that of last year and the value of deals where UK firms are buying overseas assets has been just $1.7 billion against $6.1 billion in 2015. The size of new firms issuing on the market has also fallen significantly, with EY reporting IPOs in Q1 raising just £1.65 billion rather than the £4 billion in Q4 2015.
However, the value of inbound deals, where foreigners have been buying British companies has been more robust, helped by the fall in the value of sterling making such deals more attractive. This could well point to the key to taking advantage of any further escalation of Brexit fears – potential takeover targets will be much more attractive if sterling takes another battering. Medium sized UK firms are reputedly making sure that they have responses ready should predatory bids from overseas surface quickly. For banks there have also been some positives regardless of the slowdown in deal activity, with their FX trading businesses much more active and some help to profitability coming from a fall in costs.
If we can argue that the slowdown in deal activity at banks is likely to be transitory, what about consumer spending? The consumer confidence index is at its lowest for a year, but the fall has been modest (from 113.3 in January to 112.7 in February) and has largely resulted from uncertainty ahead of the June vote. This suggests that there will be some pent up demand, from delayed purchases, which could provide a useful economic boost just when it is needed. Overall consumers have not been holding back. Even with the uncertainty – unsecured lending to households rose 9.3%y/y in February, which is the fastest pace since 2005. The new tax year may see a moderation in buy-to-let borrowing, but this could also mean that money is spent elsewhere, or better still, invested.
It would be foolish to say that the prospect of Britain leaving the EU will not have an impact on economic growth and the value of our investments. However, it may well be that such an impact will be transitory and, if the UK votes to remain, there should be some decent upside potential. For now many asset classes are looking quite fully priced, but with cheap money likely to persist indefinitely, and overseas central banks continuing to quantitatively ease, valuation levels can be pushed much higher, as this money competes for assets to buy. Keeping your powder dry for now probably makes sense, but a sharp sell-off such as that recently prompted by Mr Johnson’s decision could present a healthy buying opportunity.
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