What does Brexit mean for UK equity investors?
As the dust begins to settle after the UK’s EU referendum, domestic investors are grappling with a much altered investment landscape. In just a few short weeks, investors have seen a Bank of England interest rate cut and resumption of quantitative easing (QE), a changing of the guards at Westminster and a surprisingly strong rally in UK equity markets. What does this all mean for investors, and how could they potentially look to position their UK equity portfolios in light of these recent developments?
A look back over the last decade
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% for the FTSE 100 over the same time period. This trend of UK mid cap outperformance of UK large caps has been driven bydomestic economic growth relative to a sluggish global recovery. As the FTSE 250 has significantly more exposure to the domestic economy than the more internationally exposed FTSE 100, the mid cap index outperformed the large cap.
However, Brexit has potentially turned this trend on its head. The UK now looks set for a sharp slowdown, and potentially a recession, as businesses pull back on investment until the political outlook and the future shape of the nation’s relationship with Europe are clearer. In an environment of slowing UK economic growth and political uncertainty, the domestically exposed FTSE 250 looks vulnerable in the medium term. In comparison, the FTSE 100 with its international diversification should be relatively sheltered from changes in the UK economy.
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 factor in the large cap index’s favour. Sterling has weakened approximately 18% on a trade-weighted basis since its high last summer as fears over the UK’s relationship with the EU 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, lifting share prices.
Beyond Brexit-related factors, FTSE 100 outperformance in 2016 has also been helped by the recovery in commodities prices. Over the 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 producers—which, combined, make up 18% of the FTSE 100, one of the biggest commodity weightings in the developed market equity universe. As a result, the UK large cap index has been a significant beneficiary of the stabilisation in global commodity markets.
How long could large cap outperform mid cap?
International diversification, a falling pound and recovering commodity markets should all help to drive FTSE 100 outperformance of the FTSE 250. However, there is also a valuation argument that investors should consider. The below chart shows the price-to-book ratio of FTSE 250 firms relative to their FTSE 100 peers. The decade-long outperformance of the FTSE 250 has driven up relative valuations, making the UK mid cap space look expensive relative to the large cap space. Since the Brexit vote, we have seen signs of this correcting; however, there is some way to go before relative valuations are close to their long-run average. As a result, we are potentially at the start of a long period of outperformance by UK large cap stocks.
Source: FTSE, Factset and J.P. Morgan Asset Management; data as at 22.08.2016
Overall, the UK’s referendum decision has not just triggered a shift in the political landscape but has also had a material impact on the performance of UK equity markets. A weaker pound and a rebound in the fortunes of commodity firms could act as catalysts for significant outperformance by the FTSE 100 over the FTSE 250 for the foreseeable future.
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