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Brexit shock: the first two days

By: Tom Goodwin, Sr. Research Director

On Thursday, June 23, 2016 a referendum was held on whether the United Kingdom should leave the European Union or remain. The resulting vote to leave triggered a major sell-off of equities around the world, especially within the UK. Over the next two trading days of Friday, June 24 and Monday, June 27, the value of the FTSE 350 Index fell by over 7%.[1]

The markets have recovered some or all of their losses as of this writing, but I thought it would be instructive to drill down into the sector returns within the UK over those two days.

FTSE 350 Index and Industries (June 24-27, 2016)

Source: FTSE Russell. Data as of June 27, 2016. Returns are compounded over the two days and in GBP.

The first item to note is that two of the ten FTSE 350 Industries—Health Care and Oil & Gas—actually rose in value during these volatile two days. Health Care has traditionally been known as a “defensive” industry, one that sells products that people need to buy regardless of the business cycle, such as pharmaceuticals and medical equipment, and thus less susceptible to the effects of significant market movements. So perhaps the gains of Health Care were really no surprise.

That the Oil & Gas industry was in positive territory is perhaps more surprising, as Brent crude oil futures fell by 7.4% over the two days on weak global oil demand fears.[2]  But the result makes sense once one recognizes that many of the large multinationals in this industry have the bulk of their business overseas, where its revenue is insulated from both the UK economy and Sterling.

Crucial insights are provided by comparing the FTSE 350 Domestic and Global Exposure Indexes. These two indexes select stocks within the FTSE 350 based on the ratio of domestic/global sales revenue. Over the two trading days the UK-centric FTSE 350 Domestic Index fell by 20.86% while the overseas-heavy FTSE 350 Global Index fell by only 1.99%. Clearly, those companies with the greatest exposure to the UK economy were hardest hit by the Brexit shock.

Moreover, the pound fell by 11% against the dollar over the two-day period.[3] This meant that companies that relied on imports were hardest hit while those companies that were export oriented suffered less.

Consequently, the traditional distinction between the less sensitive “defensive” industries and risk-on “cyclical” industries that are more sensitive to the business cycle cannot explain all of the variation in returns. One also has to take into account exposure to the domestic economy and the pound as well. For example, Basic Materials and Consumer Goods are traditionally cyclical industries that one might expect market participants to flee from at a moment of economic uncertainty. But, while in negative territory, they still outperformed the broader FTSE 350 Index. That is likely because many of the companies within these industries have large overseas exposures as they include mining, metals, forestry, automobiles, and food producers.

By the same token, the traditionally defensive industries of Consumer Services and Telecommunications underperformed the broad index. These industries include food and clothing retailers, media, travel and mobile phones, all of which generate major revenue from within the UK or depend on imports which will become more expensive if the pound continues to deteriorate.

Finally, a special mention should be made of the Financials industry, which was the hardest hit of all ten industries.  Financials include banks, insurance, real estate and financial services. The Banking “supersector” fell 16.36%, triggered by economic and political uncertainty as well as the prospect of interest rates being lower for longer.[4] Even harder hit was the real estate supersector, which fell 22.76% on uncertainties in the housing market.[5]

The aftermath of the Brexit vote will be remembered for a long time. The relative performance of industries turned on the mix of domestic and global revenue, the exposure to the pound, and whether the stocks within the industry were defensive or cyclical. What direction the market takes from here is anyone’s guess, but it’s a reasonable conjecture to say more volatility is likely.

 
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[1] Unless otherwise noted, the data source throughout is FTSE Russell. The FTSE 350 Index includes the 350 largest stocks by capitalization trading on the London Stock Exchange. It includes a diverse mix of large cap and mid cap stocks, and multinationals along with exclusively domestic companies.

[2] Brent Crude contract for September 2016 traded on ICE Futures Europe. Source: Wall Street Journal online edition June 27, 2016.

[3] Source: Wall Street Journal online edition June 27, 2016.

[4] Martin Arnold, “RBS reprivatisation faces 2-year delay due to Brexit share price fall,” Financial Times, July 4, 2106.

[5] Emily Cadman, “Brexit uncertainties fuel pessimism in the housing market.” Financial Times, June 29, 2016.

 

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