Combustible Commodities, Bruised Banks: Why Brexit isn’t the only headwind for UK equities

Whisper it very quietly, lest we jinx it: UK equities have been on a strong run recently. When was the last time you could say that? Certainly not since Brexit, which has been blamed for the poor performance versus global peers. However looking at the 4 quarters leading up to and including the Brexit vote, UK equities underperformed Global equities each time. Further, if you rank performance in Sterling terms alongside US equities, European equities, Japanese equities and Emerging Market equities, the position out of 5 was:

Q3 2015:               3

Q4 2015:               4

Q1 2016:               4

Q2 2016:               4

Essentially UK equities were lagging even prior to the vote, and although performance may have been a little weaker in anticipation of the vote, expectations were that Remain would win, so perhaps other factors have also been at play. This isn’t to say that Brexit hasn’t has a negative effect, as UK equities have clearly underperformed their global counterparts since the vote:

However, like all regions, UK equities have a greater weighting to certain sectors, specifically commodity producers (miners and energy are around 23% of UK large caps) and financial services (around 21% of UK large caps). These sectors have largely been out of favour since the Global Financial Crisis, with performance lagging versus other sectors and trading at lower multiples of earnings, whereas sectors such as tech and consumer staples, with predictable/growing cash flows, have led markets and trade at much higher valuations. Also commodity prices saw a huge sell-off between 2008 and 2016, which would have seen a seen a sell-off in resource firms even if they weren’t out of favour. Admittedly this argument is in part circular: the large sell-off in commodity prices, and subsequent effect on company cash flows, in part caused investors to require cheaper valuations.

So has there been a shift in mentality from investors that has seen bank and commodity stocks move higher, boosting UK equities? Well no. In fact since the start of March global banks have significantly underperformed broad equites (the recent concerns surrounding the inability of Italy to form a government, and further concerns about what might happen if they do manage to form a government have hardly helped). On the other hand, global oil companies have performed very strongly, but this has been on the back of a 21% rise in the price of Oil since March, with no real change in valuation metrics. Further, commodities in general are traded in US Dollars, and the recent strength in the currency increases the value of sales in companies’ local currency.

So the good news for those overweight UK equities is that the commodity bear market appears to be over, and that if commodity prices remain elevated, the sector could help to keep performance competitive versus global equities. The bad news? Commodity prices could easily fall back, while there appears little sign that banks are about to have a similar rally. At the same time Brexit has, and will likely continue to squeeze the profits of firms in other sectors.

We continue to be underweight UK equities, preferring exposure to large companies which have revenues and operations around the world, which can hopefully mitigate the effects of Brexit. At the same time we increased exposure at the start of the year to funds which exhibit a value tilt which have performed well year-to-date in part due to positions in oil majors.