August 16, 2016    3 minute read

FTSE 100 Response To Brexit Explained

Cause And Effect    August 16, 2016    3 minute read

FTSE 100 Response To Brexit Explained

The FTSE 100 is currently displaying a bull market – up 14.7% from the low point after the Brexit vote. The correction reflects the large exposure companies composing the FTSE 100 have overseas. As such, possible falls in revenues due to the uncertainty created by Brexit can be cushioned by this exposure. Also, a lower pound means that income generated overseas now has a higher value in pounds. Export sensitive companies like those in the pharmaceutical and energy sectors are set to benefit the most from this development.

The Search For Yield

After the vote, many were already envisaging a UK recession and markets are highly driven by behavioural factors. Therefore, the Bank of England (BoE) had to convince markets that it would take the necessary steps to accommodate the transition through an easy monetary policy. On August 4th, the BoE announced it would cut interest rates to a 0.25% record low and expand its quantitative easing. The move resulted in a plunge in gilt rates to record lows too, with the ten-year note currently at 0.585%. As a result, it is not surprising that investors are trying to squeeze a higher return by betting on equities.

However, the Brexit story is far from over so investors should be vigilant of possible significant fluctuations in stock prices due to new developments in the matter.

Defensive Vs. Cyclical Stocks

The effect Brexit has on companies composing the FTSE 100 varies by sector. Defensive stocks, which are less cyclical and hence more immune to economic fluctuations, are less likely to be affected by the turmoil created by Brexit. An example of a sector that is usually defensive due to its primordial nature is the healthcare industry. This is reflected in the strong performance of companies like AstraZeneca and GlaxoSmithKline, which are up 25.7% and 13.4% respectively in the period since the vote in June.

On the other hand, cyclical stocks fluctuate more with changes in economic activity and hence are likely to be more responsive to the Brexit turmoil. The mining sector tends to be highly cyclical since the volume of economic activity is usually deeply correlated with demand for commodities. An example is Glencore. As shown by the highlighted trend line in the chart below, Glencore was more responsive to the threat of a slowdown in economic activity resulting from Brexit.

It is important to highlight that currently Brexit is not expected to take place until 2019, and therefore there was not much of a slowdown in economic activity to price in. Nevertheless, as can be seen in the chart, the stock price of Glencore decreased significantly during the fourth quarter of 2015, reflecting that mining sector production between Q3 and Q4 fell by 2.3%, according to the ONS. This can imply that if economic activity indeed falls after Brexit happens, stocks like Glencore are likely to price in this slowdown to a greater extent than stocks like AstraZeneca.

2016-08-17 07.26.11 pm

Source: WSJ

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