The Weekly - Fishing in the Brexit bathwater

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22/10/2019
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To say that the political temperature in Westminster has reached a new level over the last week would be an understatement. It may get even hotter as we approach 31st October. 

As money managers, we have to navigate all the noise, brinkmanship, posturing and chaos, maintain a cool head and try to deliver the best returns we can possibly achieve, within a client’s chosen level of risk. The problem at the moment is that the level of risk in the UK equity markets feels higher than normal, partly due to Brexit uncertainty and partly due to US/China trade deal uncertainty. We must keep our heads and maintain a long view of the forces that will be defining investments in the years to come. 

Despite this ongoing uncertainty, since 9th October we have seen a strong move in sterling against the Euro and US Dollar, as news came out that the basis of the current deal was progressing from a previously combative stance to one of agreement. Sterling has not looked back since and this has had a major influence on sectors within the UK market. With hindsight this looks like an inflection point and leading the mid-250 index to outperform the FTSE-100 index by 5.5% since then (Source: FE Analytics). This has been caused by a combination of two features. Firstly, the FTSE-100 is being held back as the high proportion of overseas earnings from the constituents are translated to a lower figure as sterling strengthens, which is the reversal of the benefits seen since the Brexit vote outcome. Secondly, the mid-250 index is dominated by UK domestic businesses such as housebuilders, construction, property and retail. Interestingly, there have also been circa 20% moves in businesses such as Marks & Spencer, Aston Martin Lagonda and Capita where the outlook is poor and sentiment has been very weak. 

This is where the investor has to be vigilant. We have been saying for many months that investors need to be careful that their portfolio isn’t all facing the same way. Overseas earners with high exposure to internet based disruptive business models such as Amazon, Netflix, Alphabet (Google) and Facebook have been the darlings over the last two years and have fuelled the best returns. Popular funds offered by the likes of Fundsmith and Lindsell Train have played this theme and also hold companies such as Microsoft and Paypal, as well as the likes of Unilever and Diageo for their broad-based global brands. These stocks have all retraced, as have these popular funds which hold less than 30% UK exposure, falling around 3% whilst the mid-250 has risen by 5.5%. We wouldn’t be advocating throwing any babies out with the bathwater and deserting these global companies, though, as they are highly likely to feature in the future in a major way. Having exposure to UK domestics would have been a painful position which may now be turning the corner, however, hence the dramatic moves in the last two weeks. 

The big debate right now, following the moves in sterling, is how much further this has to go and how much damage will this do to the translation of overseas earnings? The low point against the Euro was €1.077 in early August this year. This has now risen to €1.163 at the time of writing (Source: Alpha Terminal). The value just prior to the Brexit vote was €1.305 and a year prior to that, before there was any belief that the UK would leave the EU, the rate was €1.40. So, since 9th October, we have seen a 4% rise in sterling against the Euro and a 5.4% move against the US Dollar with an 8.5% performance differential between mid-250 companies and US internet darlings.  

What happens next and how should we position for this? The longevity of this move is impossible to predict as was the switch from internet darlings just after the millennium and the subsequent outperformance of defensive income stocks. 

As ever, diversification by asset class, geography and business sector is key, but also by economic cyclicality. Which, you need to ask yourself, is more likely to deliver the best returns over the next five years, Amazon or Marks & Spencer? Is Aston Martin Lagonda likely to lead the electric vehicle revolution over the next ten years? Will Google continue to be the internet search engine of choice? Will it be allowed to be, or will US anti-trust regulators split it up? The same potential risk applies to Amazon and Facebook. Always remember what you invest in, business models of now and the future, based on profits, dividends and their potential for long-term growth. One day, Brexit will be consigned to the history books, a permanent feature of the Modern History curriculum. Our grandchildren will learn about it as they search the internet and spend their pocket money on-line. It is long-term human activities, however, that really matter and inform investment decisions, not the current political chaos. 

When fishing for value in the Brexit bathwater, it is vitally important to focus on sustainable business models and not those companies which have just enjoyed a relief rally as the short-sellers have closed their positions rapidly. For the foreseeable future, we will continue to need houses, smart phones and online businesses. The flexible working revolution is only just beginning and WeWork, whose IPO has been suspended, taps into that, threatening the conventional business office, long-term tenancy arrangement. Established brands will persist but fashion now moves at lightning speed, without bricks and mortar outlets. Whichever industry you look at for investment, there is technology driving change, driven more and more by environmental considerations. These are all themes which have the potential to deliver superior returns and Brexit will have little influence on their long-term success or failure. 

 

Pound rallies on Brexit deal optimism 

Sterling enjoyed a positive week after the Government and the European Union agreed a tentative deal regarding Brexit. The domestic currency climbed by +1.7% against the US Dollar to $1.290 and +0.8% versus the Euro to €1.158, the highest level seen for five months on hopes that the withdrawal stage of Brexit would finally be pushed through.

With Sterling appreciating, the overseas focussed FTSE100 lost some ground, shedding -1.3% over the course of the week whilst the domestic focussed FTSE250 rose by +0.9%. With earnings season now in full swing, the S&P500 climbed by +0.5% with the Healthcare sector leading the way. There was mixed trading on the Continent as markets digested the Brexit news with the French CAC40 falling by -0.5% whilst the DAX30 rose by +1.0%. Meanwhile in Japan, the Nikkei 225 spiked by +3.2% in what was a holiday shortened week.

There was little movement in the sovereign bond markets with yields on both the 10-year Gilt (UK) and 10-year Treasury (US) unchanged at 0.71% and 1.75% respectively. Eurozone yields crept slightly higher as the week progressed, the German 10-year closed the week at -0.39% having risen by 18 basis points over the course of October so far on expectations of a Brexit breakthrough 
Outside of all the Brexit frenzy, last week saw the beginnings of the third quarter US earnings season and this shone a light on the corporate effect of the US tariffs to date. Earnings expectations have already been pared back significantly in 2019, taking the effect of the tariffs into account, such that forecasts are quite low. It therefore came as some relief when many of those forecasts were met. 

In the commodity markets, oil prices lost ground with Brent Crude dropping by -1.8% to $59.42 a barrel. Concerns ahead of China’s Q3 GDP data which confirmed the slowest period of growth for 26 years led the oil markets lower despite rising hopes that OPEC will extend its supply cuts. Gold meanwhile rose by +0.5% with the precious metal closing the week at $1,490 an ounce. 


The week ahead 

Clearly, political developments will dominate the domestic agenda as we once again find ourselves within arm’s reach of a Brexit deadline. Any news from the Houses of Parliament is likely to have a potentially meaningful impact on the value of Sterling, which has a significant impact on market returns. In terms of economic data releases, there is little of note scheduled this week. 

Overseas, Thursday will bring updated Durable Goods Orders which, with so much concern surrounding the state of manufacturing industries, will provide an insight into a number of industries impacted by trade wars. Meanwhile, the European Central Bank holds its latest policy meeting having already cut interest rates and announced a resumption of quantitative easing measures in recent months. No further change to monetary policy is anticipated on this occasion. 

 


The value of an investment with Rowan Dartington may fall as well as rise. You may get back less than the amount invested. 

Past performance is not indicative of future performance. 

Source: FE Analytics (information is correct as at 21st October 2019) 

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