MARKET INSIGHTS Market Bulletin September 2016 The UK economic and equity landscape post-brexit In Brief: Despite the surprisingly strong bounce in UK economic data over the summer, we remain fairly downbeat about the economic outlook heading into 2017. Brexit has not actually happened yet. Article 50 has not yet been activated and we have painfully little detail on what exit negotiations will look like. We continue to favour UK large-cap over UK small- and mid-cap for the foreseeable future. The weaker pound, rebounding commodity prices and the poor domestic economic outlook should see the FTSE 100 outperform the FTSE 250. BREXIT? WHAT BREXIT? Perhaps the Leave campaign was right: maybe nobody should listen to experts, especially economists. In the wake of the UK s referendum vote, economists reduced their outlook for domestic growth. According to the Treasury s survey of independent economists, the outlook for 2017 GDP growth has dropped from 2.1% prior to the June referendum to just 0.7% in the latest survey in August. AUTHORS However, the summer data has been surprisingly strong and an immediate slowdown appears to have been avoided. Major data points, listed below, have all come in above expectations: Services PMI (August) 52.9 vs 50.0 Manufacturing PMI (August) 53.3 August vs 49.0 Industrial production (July) 2.1% (y/y) vs 1.9% (y/y) Dr. David Stubbs Global Market Strategist Retail sales (July) 6.2% (y/y) vs 5.3% (y/y) The strength of UK economic data is reflected in the Citi Economic Surprise Index in Exhibit 1. The index measures the performance of economic data relative to economist expectations. After a strong summer the chart shows how impressively the UK economy has defied economists projections since the June referendum. Alex Dryden Market Analyst
Immediate recession fears have subdued after a surprisingly strong summer for UK economic data EXHIBIT 1: UK ECONOMIC SURPRISE INDEX Index level 100 80 Despite the strong summer of economic data, both yields and currency are significantly lower than before the June referendum EXHIBIT 2: 10-YEAR GILT YIELDS VS. GBPUSD EXCHANGE RATE 1.6 1.50 % Exchange rate vs. USD (LHS) 1.4 10-year Gilt yield (RHS) 1.45 60 40 20 0-20 1.2 1.0 0.8 0.6 1.40 1.35 1.30 1.25-40 -60 Sep '14 Dec '14 Mar '15 Jun '15 Sep '15 Dec '15 Mar '16 Jun '16 Sep '16 Source: Citi, Thomson Reuters Datastream, J.P. Morgan Asset Management; data as of 20 September 2016. 0.4 1.20 1 Jun 15 Jun 29 Jun 13 Jul 27 Jul 10 Aug 24 Aug 7 Sep Source: Citi, Thomson Reuters Datastream, J.P. Morgan Asset Management; data as of 20 September 2016. CHALLENGING TIMES AHEAD? Does the recent bounce in economic data mean that the UK economy is out of the woods? The answer is probably not. It will take some time for the full effect of the Brexit vote to be reflected in economic data. Looking at the Bank of England s (BoE) own forecasts, business investment is expected to begin to contract in the coming months as firms look to scale back their UK operations gradually over the course of this year. These expected cutbacks in investment would begin to hurt the consumer in 2017 and 2018 as workers are laid off and unemployment begins to creep back up. As consumers make up 60% of UK GDP, it is likely that it won t be until 2017 and 2018 that the threat of a pronounced economic slowdown begins to potentially creep in. As we highlight in Exhibit 2, the fact that the currency and gilt yields remain well below their pre-referendum peaks suggest that investors continue to be worried about the long-term outlook for the UK economy. SAILING INTO UNCHARTED WATERS At present, there is no such thing as Brexit. All we have had is a national vote on the subject, and the only major changes on a macroeconomic level have been the fall in the currency and a package of measures from the BoE both of which are progrowth. Ultimately, we cannot be sure what comes next for the UK as we enter these uncharted waters. We still have scant little detail over when Article 50 would be triggered, how long exit negotiations would take and what the final deal will look like. With so many unknowns, measuring the impact of Brexit is challenging. Exhibit 3 outlines the dynamics of the exit negotiations. Ultimately, there will be some trade-off between the sharing of sovereignty and free movement of labour and access to the single market for goods and services. The best way to view this chart is by separating the outcomes into a soft Brexit vs. hard Brexit. In a soft Brexit scenario, we would end up negotiating terms similar to those of Norway. This would involve us retaining access to the single market, but it would come at the cost of continuing to pay into the European Union (EU) budget, implementing a large proportion of EU laws and continuing to allow the free movement of labour. However, under a soft Brexit scenario, the economic fallout of breaking away is minimised as businesses can continue to be based in the UK and still operate across Europe. Under a hard Brexit scenario, we would lose our access to the single market which would result in more firms uprooting and moving over to Europe and would be economically the most adverse scenario. 2 THE UK ECONOMIC AND EQUITY LANDSCAPE POST-BREXIT
There has been painfully little detail about the nature of the UK s relationship with the EU going forward EXHIBIT 3: TRADEOFFS FOR THE UK POST EU EXIT MARKET ACCESS & INTEGRATION WITH THE EU Participation in EU legislation processes EU Full market access NORWAY Market access by negotiation SWITZERLAND Goods market access but not services TURKEY WTO ACCESS Free movement of labour No financial contribution Some financial contribution EU member SHARING OF SOVEREIGNTY Source: J.P. Morgan Asset Management; data as of 20 September 2016. We have had much debate, but little detail, about the future path of the negotiations. One of the challenges for the British negotiators is that although a soft Brexit is economically favourable, it is not a politically favourable outcome. Many voters who opted to leave the EU did so because they wanted to limit the movement of labour, stop paying into the EU budget and to regain some sovereignty. The concern is that very little of this could be achieved under a soft Brexit scenario. Overall, investors should expect a period of prolonged uncertainty surrounding the nature of the UK s relationship with the EU resulting in sluggish, but still positive, UK growth. This in turn is likely to see monetary policy remain looser for even longer and the pound to continue to trade close to multi-year lows against other international currencies for the foreseeable future. The challenge for investors is how to position their UK equity allocation in such an economic and political environment. UNDERSTANDING THE INVESTMENT LANDSCAPE POST-BREXIT Before looking at where markets are going, we should first review where they have been. Over the last decade, the FTSE 250 has significantly outperformed, returning 10% on an annualised, total return basis, compared to just 4% from the FTSE 100 over the same time period. This trend of UK mid-cap outperformance of UK large-caps had been driven by strong domestic economic growth relative to a sluggish global recovery, to which the FTSE 100 is more exposed. However, Brexit may have turned this trend on its head. The UK now looks set for a slowdown, as businesses look to pull back on investment until the political outlook and the uncertainty surrounding the nation s relationship with Europe is clearer. In an environment of slowing UK economic growth and political volatility, the domestically exposed FTSE 250 looks vulnerable in the medium term. In comparison the FTSE 100 with its international diversification should be more sheltered from changes in the UK economy. J.P. MORGAN ASSET MANAGEMENT 3
FTSE 100 TAILWINDS It is not just the international diversification that makes the FTSE 100 attractive vs. the FTSE 250; the weaker pound is also a major driver of large-cap outperformance. The pound has weakened approximately 18% on a trade-weighted basis since its high last summer as fears over the UK s relationship with the UK have weighed on its value. FTSE 100 firms get 75% of their revenues from overseas, which means the weaker pound gives an immediate boost to their overseas earnings and subsequently lifts their share price. The recovery in commodities market has also helped drive FTSE 100 outperformance in 2016. Year to date, the Bloomberg Commodity Index, which measures a broad basket of commodities, has rallied 9%, after falling 67% since February 2008. The potential bottom in the commodity bear market has helped lift the fortunes of struggling miners and oil-producing firms, which has helped the FTSE 100. That index has a 19% weight in commodity-producers one of the biggest in the developed market equity universe meaning that it stands to benefit the most from this stabilisation in global commodity markets. Furthermore, with UK 10-year gilt yields sitting at just 0.8%, the FTSE 100 with a dividend yield of 4.1% could be an attractive source of income in a world starved of yield. HOW LONG COULD LARGE-CAP OUTPERFORM MID-CAP? Since the referendum, the FTSE 100 has returned nearly 7%, compared to less than 4% from the FTSE 250. Our view is that the international diversification, a falling pound and recovering commodity markets should all help drive FTSE 100 outperformance of the FTSE 250 for the foreseeable future. However, there is also a valuation aspect that investors should consider. Exhibit 4 shows the price/book ratio of FTSE 250 firms relative to FTSE 100 firms price-to-book ratio. The decade long rally in the FTSE 250 has driven up their relative value, making the UK mid-cap space look expensive relative to largecap firms. Since Brexit we have seen signs of this correcting however, there is some way to go before these valuations are close to their long-run average, potentially marking the start of a long period of outperformance among UK large-cap stocks. FTSE 250 has outperformed the FTSE 100 for the last decade however, Brexit may have turned that trend on its head EXHIBIT 4: FTSE 100 VALUATIONS VS. FTSE 250 VALUATIONS Relative price-to-book value 1.4 x 1.3 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 FTSE 250 expensive vs. FTSE 100 Average FTSE 100 expensive vs. FTSE 250 0.4 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 Source: FactSet, FTSE, J.P. Morgan Asset Management; data as of 20 September 2016. A key takeaway for investors is that the UK equity market, particularly large-cap stocks, has very little to do with the underlying fundamentals of the UK economy. The UK economy may be set to veer into uncharted waters, but that may not affect the performance of UK equities. Another factor that could help UK equity markets is their exposure to the emerging world, where growth has started to stabilise in 2016. Despite a more stable growth outlook in emerging markets, it is understandable that investors may still be nervous about taking the plunge into emerging market (EM) assets. But UK equities, with their significant exposure to EM economies, can act as a proxy for the EM recovery and allow investors to feel the benefits of stronger growth in the emerging world, while having the familiarity of being invested in a developed market. Furthermore, in a world where financing costs remain low and the domestic currency has fallen sharply, overseas acquirers may see this as an ideal time to purchase UK listed firms. With that in mind we may see more merger-and-acquisition activity in the coming months as overseas investors take the opportunity to snap up some cheap rivals in the UK market. With overseas investors shopping in the UK equity markets, this may be another driver in favour of UK equities in the short to medium term. 4 THE UK ECONOMIC AND EQUITY LANDSCAPE POST-BREXIT
HOW HAVE UK FUND MANAGERS ADAPTED TO THE POST-BREXIT CLIMATE? Fund managers have held their position so far this year, but it remains to be seen whether this is a product of stubbornness or a lack of liquidity within small- and mid-cap. Over the last few years, the UK benchmark index, the FTSE All-Share, has not performed strongly. If it had been a UK equity fund manager, it would have registered 71st percentile performance in 2015. We have discussed the impact that falling commodities, a sluggish global growth environment and a strong pound has done to UK large-cap performance in our previous Market Bulletin. 1 These factors have made it easier for UK active fund managers to outperform their benchmark by significant margins. However, so far this year, the benchmark is back. The rebound in the FTSE All-Share as the weaker pound and rising commodity prices have help lift its fortunes. The benchmark year to date has registered in the top 24th percentile of fund managers. A more competitive benchmark has made it harder for UK fund managers to outperform in this environment. INVESTMENT IMPLICATIONS The UK s surprisingly strong summer has seen off the threat of a slowdown in the short term; however, the economy is not out of the woods just yet. We believe that investment cuts this year will begin to hurt consumption in 2017 and 2018, resulting in a sluggish domestic growth environment. We have painfully little detail on the nature and timeline of UK exit negotiations with the EU. Investors should expect a prolonged period of political uncertainty and volatility ahead, which will in turn weigh on UK growth. In an environment of rebounding commodities, a weaker currency and slowing domestic growth we believe the FTSE 100 will continue to outperform the FTSE 250. However, these factors will make it harder for investors to outperform the benchmark going forward. With this in mind as well as heightened political and economic uncertainty, UK equity investors should consider reducing active risk. With uncertainties looming over the UK s relationship with Europe, the direction of the currency and a more competitive FTSE All-Share, it may make sense for UK equity investors to consider their active risk in relation to the benchmark for the foreseeable future. In the longer term, however, the conclusions of the exit negotiations, which are uncertain now, are likely to result in winners and losers within the UK equity market. While it may make sense to trim active risk in the short to medium term, investors should look to be flexible as the exit negotiations continue in order to take advantage of some of these winners and losers after the negotiations conclude. 1 Are the tides turning for UK equities?, Alex Dryden, J.P. Morgan Asset Management, May 2016 J.P. MORGAN ASSET MANAGEMENT 5
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