Financial markets endured a roller-coaster experience in the second quarter of 2016.
April and May were positive months for global equities, continuing the recovery seen from the lows in mid-February. This was largely driven by the recovery in oil prices towards $50 per barrel and improving macroeconomic trends in the US. The biggest shock to financial markets over the period was the surprise vote for the UK to leave the EU, triggering a sharp drawdown in European and global equities. The knee-jerk reaction from investors on June 24 saw sterling decline sharply against its major currencies, yet by the end of the month the FTSE 100 had recovered all of its post-Brexit losses.
Overall it was a positive three months for developed markets, with the FTSE All-Share Total Return gaining 4.7%.
Investors quickly took advantage of lower prices considering that a weaker currency is beneficial for UK multinational companies that generate a significant proportion of their earnings from overseas. However, the same cannot be said for the FTSE 250, ending the month down by 5.3%. This reflects the fact that companies in this segment of the market are much more domestically focused, and more dependent on the UK for revenues. Overall we expect earnings will not be enhanced to the same extent by weaker sterling and the sector is more exposed to any economic slowdown in the UK, although it is worth remembering that approximately 50% of FTSE 250 earnings are generated from abroad.
At a time of heightened political instability, economic data on the whole points towards stabilisation in the global economy. China’s policy emphasis on shifting its economy away from manufacturing to correct its massive industrial overcapacity is supportive for global stability as this will help to prevent deflation being ‘exported’ around the world, particularly with regards to hard commodities. The rebalancing of supply and demand for oil towards $50 per barrel is also a positive development for the global economy, both providing support to energy sectors and offsetting deflationary forces.
Improving fundamentals from the US included an upward revision to first quarter GDP growth to 0.8% from 0.5%, allaying concerns about the durability of US growth. The better-than-expected data fuelled expectations of a US interest rate rise in the summer, although this may well now be postponed after the Brexit vote. There was also positive news flow for the Eurozone over the quarter, with economic growth for the region picking up ahead of expectations. The European Central Bank continues to support the European recovery, and its quantitative easing programme should help limit contagion from Brexit.
It is important to highlight that the medium to long-term impact of Brexit cannot be predicted to a high degree of confidence while the renegotiation process takes place. In the short term, lower investment and hiring intentions from firms will dampen growth, while the fall in sterling will lead to higher inflation given that UK imports significantly outweigh exports. The Bank of England now finds itself in a difficult position – lower interest rates and quantitative easing may be deemed necessary to stimulate economic growth, but this must be weighed up against inflationary pressures that would be stoked further.
We will continue to monitor UK and EU developments, including the renegotiation of trade terms and their impact on global markets. Many globally focused FTSE 250 companies have not yet seen the recovery experienced by their ‘blue-chip’ counterparts. While trends in the UK balance of payments point towards further downward movement for the currency, we think this provides an opportunity to be selective towards companies that we favour with robust overseas earnings.