Despite Brexit fears, fundamentals still prevail

If ever there was a clearer example of how the stock market can defy consensus opinion, the past three months provide a textbook case. In January it was hard to find anyone other than gloomy about prospects for the UK. The Brexit fog had become impenetrable. Fund managers worldwide were avoiding UK companies as if they had been struck down by some deadly plague. And UK investors were pulling out of domestic equity funds and trusts as clarity and confidence ebbed.

A perfect opportunity, then, for contrarians – and so it proved. The FTSE 100, instead of tumbling further down from around 6,600 at the year end, began a slow and fitful recovery. And as the shambolic chaos in the UK parliament grew ever more raucous, the market seemed to draw strength and rally further. By the middle of last week, the FTSE 100 had nudged over 7,355 for a gain of just over 11 per cent in less than three months.

Nor was the FTSE 250 left behind. This index rallied by some 14 per cent from its 17,090 end December level to 19,551 by the middle of last week.

After such a flying start to what had been written off as a year to avoid, it was almost inevitable that some profit-taking should set in and some gains were pruned. The trigger was a forecast update from the US Federal Reserve widely seen as a warning of a slowdown in the world’s largest economy. Last Friday saw some two per cent being knocked off the FTSE 100 as it retreated to 7, 207, trimming the gain since January to nine per cent. The FTSE 250 also sagged by 1.8 per cent to 18,998.

It seemed the market rally that had come from nowhere was coming to its senses. But the big question for investors was not so much why the market sold off last Friday than why it ever came to mount such an unexpected rally in the first place.

It can’t have been that investors were suddenly persuaded of a cheerful resolution of almost three years of Brexit fulmination. Indeed, looking to the political turmoil set for this week, with the growing prospect of a prime ministerial resignation and a general election not far behind, further volatility looks almost guaranteed.

My sense is that “the market” is no more sanguine than the rest of us about the UK’S political crisis and events immediately ahead. What lay behind the rally of the past three months was a calculation as to whether the “UK avoidance strategy” of the preceding period had gone far enough and whether Brexit risk had become sufficiently discounted as to merit some opportunistic bargain buying.

Since the 2016 EU referendum, UK shares have been increasingly shunned. According to fund manager Schroders, quoting a recent Bank of America Merrill Lynch survey, the consensus opinion has been to hold UK equities at a level 25 per cent under the global benchmark weighting by market capitalisation. For good measure, Morgan Stanley research noted the UK stock market was at a 30 per cent discount to its peers, a 30-year low.

Thus, last year, against a 4.9 per cent decline in the MSCI World index, the FTSE All Share index fell 12.9 per cent. Yet this seemed blind to the fact that companies listed in London generated just 27 per cent of their revenues from the UK last year, with 73 per cent derived overseas.

How much Brexit discounting was too much? In recent weeks a sufficient number of asset managers had come to the view that the Brexit risk premium had gone high enough as to warrant a relaxation of the “avoid UK” allocation stance. Giving succour to this view were the latest OBR forecasts that the UK was not, after all, heading for recession but set to enjoy a recovery – albeit paltry – to 1.6 per cent growth from 2021.

Also supporting the case for an easing of the avoid UK consensus were figures on employment growth, the continuing fall in the UK government’s budget deficit and signs that consumer spending and retail sales were proving more resilient than had been thought earlier in the year.

Finally there is strong dividend appeal, with UK companies sporting attractive yields. Last week I spoke to Simon Gergel, investment manager at Merchants. The trust aims to provide an above average income and longterm capital growth through investment in higher-yielding UK companies. Biggest holdings are Glaxosmithkline, Royal Dutch Shell, Imperial Brands and HSBC.

He points out that the UK market has been yielding 80 per cent more than the global average and that more than 30 per cent of FTSE 350 companies offer a dividend yield of five per cent or more (Merchants at 484p is yielding 5.3 per cent). Many companies, he argues, have been offering really good value, though with the caveat that dividend should not be the only consideration – investors should check dividend cover and the outlook for earnings growth. Even allowing for a Brexit sting in the days ahead, fundamentals, it seems, come to prevail in the end.