The UK’s domestically-focused index is hit hard after a long run of outperformance
Britain’s vote to leave the EU has unleashed global market turmoil and the FTSE 250 index, focused on the domestic economy, registered its biggest two-day loss since October 1987, down nearly 14 per cent.
The equity index, in simple terms, comprises medium-sized manufacturers, service companies and retailers, who unlike the very large international constituents of the FTSE 100, are likely to be highly exposed to any UK recession.
As traders returned from a weekend spent assessing last Friday’s stunning slide in share prices, the FTSE 250 was hit hard, tumbling nearly 7 per cent in afternoon trade in London. The FTSE 100 of global blue-chips was 2.6 per cent lower, reflecting the greater diversification of its companies, many of which will benefit from stronger foreign revenues as the pound depreciates.
After a sustained, seven-year period of outperformance for the domestic benchmark, the implications of Brexit for the UK economy leave the FTSE 250 looking highly exposed. Domestic equities also face further pressure from fund managers racing to trim exposure to the 250 index after it outperformed the FTSE 100 by around 90 per cent since 2009.
Paul Markham, who manages a £4bn global equities fund at Newton Investment Management, says: “The market has already decided to make for the door in terms of the sectors that will be hurt.’’
He adds: “The problem for the FTSE 250 is the potential for recession that will hit the more consumer discretionary sectors. There are also cyclically focused companies, like engineering stocks, that could be hit by cuts in capital expenditure.”
For small and mid-cap stocks, the profit warnings have already started.
EasyJet, the budget airline, has cautioned that Brexit-related uncertainty will hit its income, sending revenue per seat at constant currency in the second half “down by at least a mid-single digit percentage” year on year.
There are expectations of a series of similar profit warnings from constituents on the FTSE 250, as damage to the UK economy from Brexit looms.
Some investors, however are holding firm for now.
James Illsley, the portfolio manager of JPMorgan’s UK Equity Core Fund, says he has no plans to overhaul the roughly 17 per cent of his assets under management allocated to the FTSE 250, with 80 per cent in the FTSE 100 and the remaining 3 per cent in small-cap stocks.
“We won’t be making a huge change to the allocation, but will be doing so at the margin, the relative attractions of stocks earning revenue overseas are increasing. The change in the value of sterling will set the pace.”
Sebastian Jory, a strategist at Liberum, warns that retailers will face particular pressure: “With most retailers facing costs in dollars and selling in sterling, a weak pound will hit gross margins.”
Now that oil and metals prices have stabilised, and the outlook for the UK economy is in flux, the UK’s second-tier index, which generates 50 per cent of its revenues from inside the UK, looks all the more exposed by its previous bout of outperformance.
The steep and continued decline forecast for the pound offers a buffer for the UK-listed companies that earn their revenue in foreign currency, offering the more international FTSE 100 relative support compared with its mid-cap counterpart.
“The FTSE 100 has 75 per cent of sales outside the UK and barring any immediate trade restrictions they should benefit,” says Karen Olney, a strategist at UBS.
For the FTSE 100, the run lower in the pound may also entice international suitors, providing further support for big blue-chips.
Larry Hatheway, chief economist at asset mangers GAM, says: “One can certainly imagine M&A somewhere down the road given the attractive prices for foreigners of UK assets, but it does feel like it is further away, simply because of the pall of uncertainty that overhang.
“We should know that, if we look at a broad macro sense, any time since the financial crisis, we’ve been offered some pretty extraordinary pricing of things, but business investment and M&A have been pretty laggardly.”
The same cannot be said for the economic impact and a bleak outlook for company earnings.
“Within the UK, domestic cyclical plays and financials have above-average earnings sensitivity to GDP growth. They are likely to be the most negatively impacted if the UK economy slows down,” analysis from JPMorgan Cazenove says.
There are, however, areas where the outlook is more consistently bleak — where large and mid-cap companies alike are likely to face sustained pressure.
Housebuilders and other stocks exposed to the UK housing market look set to face a particularly strong blend of negative factors. Liberum describes “the combination of slowing growth, rising longer-term rates and political uncertainty is like Kryptonite for this group of shares”.
Persimmon, the UK’s biggest housebuilder, fell 28 per cent on Friday, the day the referendum vote was announced, and lost nearly 14 per cent on Monday.
So where are there likely to be areas of outperformance?
Liberum’s Mr Jory points out that there will be opportunities within this broader pattern, even among retailers: “We favour picking up those stocks that have significant international exposure to buy on Brexit weakness. Within this group those with sales in dollar-linked currencies should be better protected in the event that the euro also trades off against the dollar.”
Société Générale expects the defensive properties of consumer staples stocks to shine during the outbreak of extreme volatility.
“Growth and high-quality segments like consumer staples should be relatively resilient in this market environment, as a lack of visibility on the impact Brexit will have on overall global growth should support further risk aversion,” says Roland Kaloyan of SocGen’s European equity strategy team.
