Market Review – June 2016

• The EU referendum was the main event, impacting upon global markets both before and after the vote.
• Sterling weakness boosted international earners, but banks and domestic stocks were hit hard.
• Flight-to-safety trades boosted government bonds and precious metals.

The UK population voiced its opinion on June 23^rd and the EU referendum dominated newsflow and market action over the month.

After an emotion-fuelled month before the vote, the markets were clearly positioned for a “remain” outcome and hence market reaction was significant when the “leave” vote was confirmed.  Much of the negative action immediately after the vote can be put down to short-covering and safe-haven buying.  Most long-term investors were in too much shock to actually do anything.  And why should they?  A great big spanner has been shoved into the economic machine, so how do you price assets when any hope of visibility has evaporated?

In equities, there is a beautiful irony to the fact that the poster child of the storm, the FTSE 100 index, was one of the strongest markets for the month as a whole.  It was a different story for the mid-cap index, which took the brunt of the fears regarding the impact of political and economic uncertainty upon the domestic economy.  The resulting weakening of sterling can take a bow for its role in instantaneously boosting the earnings of those companies with overseas revenues.  Foreign investors in UK assets are not feeling so comfortable; in US dollar terms, the main UK equity market was one of the weakest on the global stage.  At the beginning of July, sterling reached a 31-year low versus the US dollar.

European equity markets were notable underperformers, particularly peripheral markets and, not surprisingly, Ireland.  Investor fears again centred upon UK and European banks, some of which saw precipitous falls in their share prices.  The non-performing loan problem in the domestic Italian banking system is arguably a more immediate problem for Europe than Brexit, with PM Renzi and the EU in a political stand-off.

The US market ended the month pretty flat while the Japanese market was weak; in both cases, sterling-based investors benefited materially from currency moves.  The Japanese yen continued to attract safe-haven flows in spite of the deteriorating economic picture there.   Asian and emerging markets were broadly positive.

Government bonds benefited from flight-to-safety moves and the gilt market delivered a particularly strong return over the month.  Investment grade credit markets were also in positive territory, although to a lesser degree than government bonds, while high yield bonds and subordinated financial bonds were relatively weak.

It is worth pausing to reflect upon current government bond yields in major markets.  At the time of writing, 10 year UK gilts stand at 0.77%, 10 year German bunds are at -0.17%, 10 year Japanese JGBs are at -0.29% and 10 year US treasuries are at 1.38% (source: Bloomberg, 08/07/16).  As Mark Carney said in his speech last week, the Bank of England is pretty much at the end of the road for monetary policy.  Governments are now faced with the need to take more radical steps to fire up the febrile global economy, to which Brexit has just dealt another body blow.

In commodities, precious metals led the way, with gold and silver performing strongly (particularly silver this month).  The gold price has risen by almost 25% in the first half of the year.  The oil price fell modestly but year-to-date, it is strongly positive after touching its lows at the beginning of the year.

Review of Q2 2016

The traumatic end to the second quarter made markets feel rather worse than they were in reality.  A misguided dose of pre-referendum optimism was erased in the immediate aftermath of the vote but the FTSE 100 index then moved ahead, leaving the quarter’s return firmly in positive territory.  As we mention above, the FTSE 250 index has had a much tougher time and it is languishing in negative territory for the quarter and the year.

Overall, equity markets lacked clear direction over the quarter and there was a great deal of short-term sector rotation below the surface.  The beginning of the quarter saw the banking sector across Europe recover some of its poise after the earlier weakness, but this trend petered out as the weeks drew on and as the troubles in the Italian banking system intensified.  According to The Economist, Italy’s banks have €360 billion in souring loans, equivalent to a fifth of the country’s GDP.  €200 billion of bank bonds are held by retail investors and a “bail-in” is therefore politically unacceptable, setting PM Renzi on a collision course with Brussels.

Elsewhere, at the sector level (from a UK market perspective), the leaders featured an unusual mix of the energy and commodity sectors and the more defensive pharmaceutical, tobacco and utilities sectors.  Leisure, general retailers and food producers were under the greatest pressure.

The US market made modest progress but, here again, markets have been in a consolidation mode for many weeks.   Technicians point out that the market could break out to the up or the downside from here.  The June payroll number has just been published and you can take your 50/50 bet as to whether the strong number is taken as a positive for the market (the economy is still rolling along) or a negative (will interest rates move up sooner than hoped).  What we do know is that valuation metrics remain challenging, leaving investors exposed to shocks from whichever direction they come.

The Japanese market was weak in local currency terms over the quarter but the yen rose strongly in value, given its traditional safe-haven appeal.  This meant that sterling investors benefited from an allocation to this market.  Similarly, Asian and emerging markets delivered strong returns to sterling investors, while local currency returns, in aggregate, were more pedestrian.

Sovereign bonds powered ahead over the quarter, particularly longer duration bonds, although much of this move was seen in June.  Index-linked bonds also performed very strongly.  Higher grade credit also delivered robust returns while the riskier areas of the credit markets, as represented by sub-ordinated financials and high yield bonds, achieved more modest returns.

Commodities were the star turn again for the quarter.  The oil price rose by more than 20%, as did the silver price, albeit with high volatility.  The gold price was also robust.  In currencies, sterling was clearly in the spotlight and fell by around 8% in the month of June versus the US dollar and the euro, having made gains earlier in the quarter.  For the half year, sterling has fallen by around 10% and 12% respectively against these currencies.

Market thoughts and strategies

The fog of Brexit has clearly added a new dimension to the world’s worry list.  Markets are in the process of pricing uncertainty into the areas seen as most vulnerable.  During the past couple of weeks, this has played out painfully in the commercial property sector and suspensions and fair value adjustments are creating nasty flashbacks to 2007.

Equity markets re-price far more quickly and efficiently of course and investors tend to be more comfortable with the concept of share price falls through an exchange, rather than through the more subjective art of valuing properties.  Since the vote, there have not yet been any commercial property transactions for them to refer to and therefore real price discovery simply is not there.  There appear to be buyers in the wings but opportunistic bids will be the name of the game.  More positively, the value of assets residing in open-ended commercial property funds represents only 5% of the overall market (according to The Economist) and so the drama of the headlines belies a smaller-scaled problem than we might otherwise fear.

Our recent blog, “Life after the referendum – time to get excited…?”, reinforces the ongoing cautious stance that we have put forward for many months.  Putting aside the political mess that lies before us, there is nothing normal about government bond yields hitting new lows whilst the US equity market nears its all-time highs.  The adjustment process, when it comes, will be difficult for most asset classes.  This explains the rise in the price of gold, an asset that tends to shine in uncertain times when investors face a lack of alternatives.

Good diversification is the main antidote for directionally-positioned portfolios when the outlook is so uncertain.  Selected funds from the IA Targeted Absolute Return sector have merit if you wish to invest cautiously (see our IA Sector Overview).  As we emphasise in the Overview, the sector features funds that are appropriate for a wide range of risk appetites, so careful selection is warranted.  The last year has been tough and therefore it is a helpful time period to review and analyse the risk and return characteristics of different types of funds.

IA Sector Highlights

Much of the UK equity market pain this year has been meted out on mid and small-cap companies, which logically sees funds with a bias further down the market cap spectrum residing towards the bottom of the performance tables.  Funds with significant exposure to banks and other financials have also been under greater pressure.  A reasonably good quarter for value-biased funds helped them to build upon a strong first quarter.

In European equities, growth-biased funds have continued to lead the way and cyclically-exposed/financials exposed funds have struggled.  In the US, more defensively positioned funds and income strategies have been in favour while growth-biased funds have been under pressure.  The Global sector has once again been skewed by the strong performances from resources funds.  Global income strategies have also performed relatively well.  Japan has been a particularly difficult market this year; growth and small-cap strategies have continued to be the outperformers while value-biased strategies have struggled.  Asia and emerging markets have been more of a mix, with geography playing its part as ever.  Income funds have generally performed relatively well.

In fixed income markets, sovereign bonds and higher quality bonds have served investors well, with high yield lagging but still in positive territory.  The majority of funds have less interest rate risk in their portfolios than indices, hence active funds, in aggregate, are underperforming.