When equity markets rally: The impact of Brexit
05 May 2017 | Markets and Economy
Commentary by Giulio Renzi Ricci, investment strategist, Vanguard Europe.
Financial markets experienced some turbulence in the days around the 2016 Brexit vote and have recovered well ever since. The depreciation in sterling was a key contributor, but the rally has been far from homogenous across economic sectors.
Equity markets in the United Kingdom recoiled strongly in the immediate aftermath to the referendum. On the day following the vote the FTSE 100 fell 3.1%. The FTSE 250 fell 7.2%, its worst single-day fall in more than 25 years.
Many investors, it might seem, had bought into "Project Fear", a campaign theme prominent in the weeks prior to the vote. This had predicted a possibly recessionary slowing of the economy. It was thought that consumers would postpone spending, and companies put off investment, until the implications of Brexit became clearer.
It was a logical argument, and as the long, complex negotiations between the UK and the European Union play out over the next two years, it may still come back to haunt us.
The sense of foreboding was still strong enough six weeks later that the Bank of England felt justified in cutting interest rates from the 0.5% that had been thought sufficient during the financial crisis, to 0.25%. It supplemented the cut with new funding for banks and an additional tranche of quantitative easing.
But by that time, the equity market had already changed its mind. On 5 August 2016, the day after the BoE announced its package of stimulus measures, the FTSE 250 overtook the peak last seen on the day of the referendum and by the end of March 2017 was up 9.4%.
The FTSE 100 saw a similar trajectory. It rose 6.5% in the week prior to the Thursday, 23 June vote. By the following Monday, when the "Leave" result was fully known, it was down nearly as much. A week later it was up nearly 4%. By end of March 2017 it was up 15.5%.
Figure 1: Investors changed their minds soon after the referendum
It's been an equity market rollercoaster.
The sharp fall in sterling relative to both the US dollar and the euro, immediately after the Brexit vote, has been a key factor. Typical companies in the FTSE 100 include large banks, oil and gas companies, insurers, pharmaceuticals and miners – businesses which typically draw significant percentages of their revenue from overseas. By many estimates, as much as two-thirds of FTSE 100 earnings are from outside the UK. Therefore, a weakening sterling can boost exports and projected earnings, leading to an increase in equity prices.The FTSE 250 is a less globally exposed index, including more companies with a domestic focus. Figure 2 shows the price change in some FTSE 250 sub-sectors on the day following the Brexit vote and up to the end of March 2017. Broadly speaking, although all sectors were negatively impacted immediately after the "Leave" decision, those with more international earnings tended to recover well since the Brexit vote, whereas sectors with a domestic and consumer orientation like real estate, retail and consumer goods and services, tend to have struggled more.
Figure 2: Not all sectors have benefited equally
What conclusions should we draw? The key changes were one-off adjustments in monetary policy and the exchange rate. These are, of course, important considerations in determining equity valuations, but the adjustment effects are relatively short-term. We should be careful about expecting them to support long-term returns. Above all, the suddenness of the twists and turns should be a caution against market timing.
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