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UK equities outperform as sterling drops sharply

Please see below up-to-date commentary from Brewin Dolphin, received late yesterday. The article provides insight into mixed market performance with Covid-19 and Brexit developments noted as current contributing factors. 

Equity markets were mixed last week as markets struggled to gain traction amid a flow of (mostly) worrying news. There was the worsening second wave of Covid-19 in Europe and the announcement of tighter restrictions on socialising in the UK. Then, a potential hitch with the AstraZeneca vaccine, added to increasing worries of a no-deal Brexit. On the financial front, perhaps the most remarkable development was the 3.5% fall in sterling which likely helped the FTSE100 outperform its international peers over the past week.

Last week’s markets performance*

• FTSE100: 4%

• S&P500: -2.5%

• Dow: -1.66%

• Nasdaq: -4%

• Dax: +2.8%

• Hang Seng: -0.77%

• Shanghai Composite: -2.83%

• Nikkei: +0.86%

*Data for the week to close of business, Friday 11 September.

A mixed start to the week

Equity markets in the UK and Europe turned in a mixed performance on Monday despite encouraging news about the resumption of the AstraZeneca/Oxford University vaccine trials in the UK.

The FTSE100 closed 0.1% down on Monday and the more domestically focused FTSE250 rose by 0.7%. Sterling rose 0.76% against the dollar to $1.289, and by 0.42% against the euro to €1.085.

In Europe, the pan-European Stoxx600 gained 0.15%, the German Dax fell by 0.07% while France’s CAC-40 closed up by 0.35%.

In the US, however, the positive vaccine news from the UK helped boost sentiment, as the Dow closed up by 1.2%, the S&P500 rose by 1.27% and the Nasdaq rebounded by 1.87% to 11,056.65.

Analysts said hopes about an early vaccine were tempered by concerns about rising Covid-19 cases in the UK and Europe leading to tighter suppression measures, with a consequent dampening of economic activity.

In early trading on Tuesday morning, UK shares were heading up.

Brexit is back

The developments over the last week have suggested an increased risk of a no-deal departure. And just as in previous bouts of Brexit-related stress, the worse things go, the greater the pressure is on the pound. The fortunate thing from an investment perspective is that this tends to be supportive of UK bonds (which perform inversely to the UK economy), and also UK equities, because of their inverse sensitivity to the level of the pound. In other words, when the pound falls, all other things being equal, most UK equities rise.

This might seem counterintuitive, but the reality is that the sensitivity of even UK equities to the UK economy is generally low and mostly limited to a small number of sectors, such as retail, real estate, home construction and banks. More broadly, the overall market tends to be more exposed to the overseas currencies in which its revenues are denominated. For example, around 75% of the earnings for companies in the FTSE100 come from overseas and so are denominated in foreign currencies. Therefore, when the pound falls, these earnings are worth more in sterling terms and this helps UK equities.

Overseas equities, unsurprisingly, are even more inversely sensitive to the level of the pound as they are both denominated in foreign currency and economically linked to revenues received in other currencies.

Below we show the % change in trade weighted currency, the top graph shows 2015 to present and the bottom chart shows the period from 15 May 2020 to present.

What this means

All of which means that, ultimately, we don’t see Brexit as a material investment risk. Paradoxically, the greater issue for us is how to protect wealth when Brexit risks subside because, under those circumstances, we would expect to see the pound rise and bonds (and possibly equities) fall – again, all other things being equal.

So how do we see Brexit developing? It seems likely that the current standoff is another episode of the brinksmanship that has been exhibited throughout the last four years. The intention of the government is to pressure the EU into making some concessions on fishing and, most notably, state aid. Most outstanding issues between the EU and the UK seem reconcilable, but the state aid point is one the UK government seems to want to push. Why? It seems like the government wants to ensure it can do everything it can to support strategically sensitive industries such as technology and renewables. This idea of a “Made in UK” strategy to match the “Made in China 2025” strategy is what the European’s are afraid of. It seems likely that, when push comes to shove, the UK will be forced to find a way of discreetly backing down – but we can’t be sure.

Covid-19 developments

This also comes with an adverse trend in relative Covid-19 performance as well. America’s renewed surge in cases which began in the Midwest has failed to gather pace while some large states are seeing further improvement. Progress is not universal, however, and as we can see from Europe, a true second wave is likely in the US at some point. But for now, the US case growth numbers are improving which is helpful for Donald Trump as we approach the election in November.

Case growth in the UK, on the other hand, has accelerated. This prompted the government to impose new restrictions that came into effect from Monday to great consternation from the back benches. Evidence continues to point to Covid-19 as a continuing threat with the low rate of hospitalisations during France’s second wave now beginning to pick up. The concern here is that young people are spreading the virus amongst themselves and then introducing it to older generations of their families.

Covid-19 and your investments

Regarding the investment risks of a second wave of Covid-19, we believe that investors already expect successive waves until such time as there is a widely available vaccine. The question from an investor’s perspective therefore is not so much whether further waves come, but what the impact is on perceived valuations.

Understanding how the market reacts to that is not trivial. However, we should distinguish between what we saw in the early part of 2020 which was a shock, from what we might see in future periods, which will be more of an evolution of a known risk.

When we had the shock in March it was largely because the structure of the policy environment and the market were both set up for late-stage economic expansion. That is quite typical for the entry into a recession and is the reason that equity markets react so poorly to the onset of recessions.

On a valuation basis, the loss of a year or two’s worth of earnings is bad news but would not justify the falls seen earlier in the year – hence markets were able to rebound substantially.

With Covid-19 much more of a known-unknown, and with market expectations of ebbing and flowing regional measures to try and slow those waves, we acknowledge that Covid-19 remains an important factor for the market, but it should form part of the ‘wall of worry’ that markets often find themselves climbing.

Wall of worry

The cliché about climbing the ‘wall of worry’ describes the way in which markets are often resilient in the face of known risks. It assumes investors gradually become resigned to the fact that these issues will be resolved in due course and reflects the way in which the overly cautious gradually get sucked into the improving narrative. It is helped by such circumstances also tending to coincide with periods when monetary policy is very supportive.

One more handhold on that wall came from the news that the testing of AstraZeneca’s vaccine has been paused. Although one of the front runners, this was not the only candidate. However, over the weekend it emerged that the trial would resume in the UK and India, but it remains paused in the US.

Also providing a great deal of angst is the planned end to the furlough scheme next month. Chancellor Rishi Sunak is under a great deal of pressure from lobbyists and trade unions to extend the scheme further to prevent a “tsunami” of job losses this autumn.

An extension would not be without international precedent. Germany has announced an extension to its Kurzarbeit scheme, which gives financial aid to employers while allowing them to reduce employees’ hours. It had been scheduled to finish in March 2021 but has been extended for another year. France has also extended its version of the furlough scheme but has tweaked the rules so that employers must reduce hours for workers rather than keep them off work altogether. If the British government is going to follow suit, it is leaving it late.

We strive to update our blog content regularly in order to provide the most relevant and accurate data so please check in again with us soon.

Stay safe.

Chloe Speed

16/09/2020

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Invesco Investment Intelligence – weekly performance update

Please see below for Invesco’s latest Investment Intelligence Update:

News flow last week, such as Non-Farm Payrolls and the ISM surveys in the US, was generally supportive of a positive tone in financial markets. “V” looks the shape of the recovery, for now at least. The virus news, however, remains mixed. New confirmed cases continue to roll over in the US, albeit still at elevated levels, while in Europe and DM Asia case growth remains relatively low, although it has risen in recent weeks. Case growth continues at elevated levels in Latin America.  Central Bank dovishness remains very much the order of the day, with the Bank of England last week reiterating the uncertain outlook and the preparedness to do more if needed. Geo-political strains between the US and China refuse to go away, and in fact look as if they are escalating, while progress towards further US fiscal stimulus continues to frustrate.

Global equities hit their highest level since the bear market low during the week and are now back into positive territory for the year, now just 3% from their all-time high. Small caps and value/cyclical sectors led the way. In the UK further £ strength weighed on FTSE 100 relative performance, which dragged the All Share lower.

There was mixed performance in fixed income, with government bonds weaker at the margin, with the odd exception (Italy, EM). IG and HY continue to make progress. A new record low for yields for the former, while further declines in yields for the latter returned the asset class to positive territory for the year. Spreads for both still remain well above the lows seen earlier in the year.

The US$ halted its decline (see Chart of the week). Economic optimism helped boost economically sensitive commodity prices. China, the world’s biggest consumer of copper, saw record imports for the second straight month. Gold pushed to new highs as real yields declined to record lows and investor demand remained elevated.

 Market performance last week (%)

Past performance is not a guide to future returns. Sources: Datastream as at 9 August 2020. See important information for details of the indices used.1

YTD market performance and YTD low (%)

Past performance is not a guide to future returns. Sources: Datastream as at 9 August 2020. See important information for details of the indices used.1

 Chart of the week: US$ Index

Source: Datastream as at 8 August 2020.

  • One of the features of financial markets since the peak of the pandemic crisis dislocation in late March has been the weakness in the US$. In this chart we use the US$ Index (DXY) as a proxy for the currency’s performance (Fixed currency weights for DXY are Euro 57.6%, Yen 13.6%, £ 11.9%, Canadian $ 9.1%, Swedish Krona (SEK) 4.2% and Swiss Franc 3.6%).
  • At its YTD peak (late March) it had risen just under 7% on the back of its safe-haven, reserve currency characteristics and a shortage of US$ liquidity. Since then it has given up all those gains and more, declining 9.1% and now down just over 3% YTD. It is now at levels last seen in May 2018 and its 100-day decline has been the worst since November 2010. The major contributor to this weakness has been strength in the Euro (10.3%), given its high index weight, but other currencies have been stronger (SEK +18.7%, £ +11.1%). The Yen has been the weakest on a relative basis, but has still risen 4.6%.
  • Why has the US$ been so weak? A number of factors have contributed: the global rebound in growth has favoured more cyclical currencies, such as the Euro; an unwinding of safe-haven flows into the US$ on the back of this; real and nominal interest rate differentials between the US and another major markets have collapsed; aggressive Federal Reserve policy has alleviated US$ funding issues; fiscal and structural optimism in Europe on the back of agreement on the European Recovery Fund; the Federal Reserve and US government is happy to see a weaker currency; and finally, idiosyncratic US political and fiscal risk. All have weighed on a currency that on most measures was overvalued and where investor positioning was extended.
  • Can the US$ weaken further? Fundamentals are currently stacked up against the currency for now, but this is in the context where the DXY has moved from its most overbought level ever (relative to its 12m average) to its most oversold level since 1978. At the same time investor positioning (based on CFTC data) is now at a record short.
  • What does US$ weakness mean for financial markets? Historically it has benefitted global equites (and non-US stocks in particular), cyclical sectors, EM assets in general and commodity prices, such as Gold and Copper.

Key economic data in the week ahead:

A relatively quiet week ahead on the data front.

In the US there is July’s CPI reading on Wednesday. Headline inflation is expected to rise slightly to 0.7%yoy, off the pandemic lows, but still at the lowest level since 2015. Core inflation is expected to see a marginal decline to 1.1%yoy, its lowest level since 2011. The pandemic has been disinflationary. Initial jobless claims out on Thursday are forecast to show another 1.4m people receiving unemployment benefits, despite the better than expected Non-Farm Payroll data last Friday. Data on the strength of the US consumer is also out, with US retail sales for July published Friday and forecast to show a slowing recovery (1.9%mom vs 7.5%mom in June), while the preliminary reading of the University of Michigan Sentiment Index is expected to fall further and continue to hover around pandemic lows.

In the UK the most anticipated datapoint next week is the Q2 GDP release on Wednesday. If the forecasts of -20.5% prove right it would be the worst quarterly contraction of the UK economy on record. Broad-based weakness is expected, with the increase in government spending the only positive, depending on your point of view. Monthly GDP for June will also be released at the same time, which should show an underlying improving trend in the economy not seen in the quarterly numbers, with 8%mom forecast compared to May’s 1.8%mom. The latest UK unemployment report is published on Tuesday. The unemployment rate is expected to rise only slightly to 4.2% from 3.9% as the labour market continues to be underpinned by the government’s job retention scheme. The true health of the labour market will be seen away from the headline data in areas such as the number who are now economically inactive, hours worked and vacancy levels. These all point to higher levels of unemployment by year end, with the Bank of England’s Monetary Policy Report last week seeing it at 7.5%. Finally, there is July’s RICS house price data on Friday, which is expected to show a -5% drop in July, but up from -15% last month, highlighting the gradual improvement in the housing market in England and Wales.

China’s July data pipeline started last week and will continue throughout this week with figures on CPI (Monday) industrial production, fixed investment, retail sales, house price inflation and unemployment (all on Friday). Most indicators are forecast to post better readings than they did in June, suggesting that the third quarter is off to a relatively firm start.

Nothing of note during the week from either the EZ or Japan.

An insightful look into the markets by the experts at Invesco. These weekly updates are useful in terms of providing a regular overall view of the market.

Please use Invesco’s Investment Intelligence updates as well as our other blogs to refresh your view of current goings on in the global markets.

Keep safe and well.

Paul Green

11/08/2020