UK Equities: Should I Stay or Should I Go?

The potential of a ‘Brexit’, UK citizens voting to leave the EU in the referendum on 23 June, is a tailrisk event investors have had to wrestle with for what now seems like some considerable time. While the latest opinion polls have shown a surge in favour of remaining in the EU, uncertainty has continued to influence the UK’s financial markets.

With the decisive vote just one month away, we explore whether the UK equity market stands to gain from a remain vote, particularly now that the latest economic data has broken the recent run of disappointment. Most notably, in the labour market, the claimant count fell by 2,300 in April, reversing the rising trend in unemployment. And retail sales, up 1.3%, bounced back last month, taking sales up 4.3% over the last year. After a less?than?spectacular GDP reading for the first quarter, this latest news should precipitate an improvement in investor sentiment, with the soon to?be?released CBI distributive trades survey expected to signal further good news from the UK consumer.

At this juncture, investors positioning their portfolios for a remain outcome may wish to consider the potential opportunities from UK equity indices and European financials. Non?sterling?based investors, particularly those with euro?denominated investments, could also consider positioning their portfolios to benefit from any strengthening of sterling.

Poll position: Driving Sentiment
Opinion polls have been oscillating since last autumn and it’s only recently that the remain camp has enjoyed a widening lead. But with different polls still suggesting a range of results, it’s not easy for investors to assess the likely outcome of the referendum. In the recent past, opinion polls appear to have become a less?reliable indicator, particularly against a backdrop of rising populism across Europe. Uncertainty about the outcome of the vote has the potential to contribute to volatility for UK assets, equities in particular.

Figure 1: Year?to?date results in UK referendum polls (%)

Source: Bloomberg Finance L.P., as of 20 May 2016. For illustrative purposes only.

Volatility has been very visible in the currency market, and sterling has weakened against both the US dollar and the euro. However, sterling has experienced a rebound recently and likely remains underweight in most portfolios while investors await the outcome of the referendum. Figure 2 shows the evolution of sterling and the implied volatility of the EURGBP one?month ‘at the money’ option. This measure of expected future volatility indicates the level of investor uncertainty – after having fallen late in the first quarter, its recent rise signals growing concern about the outcome of the referendum.

Figure 2: Sterling’s evolution and volatility, January 2015 to 20 May 2016

Source: Bloomberg Finance L.P., as of 20 May 2016.

Flows and Performance
While European?domiciled ETF flows have shown improved sentiment towards UK bonds and equities since the start of the year, recent flows have been somewhat lacklustre. However, with US$2.34 billion in net new assets across 68 UK bond and equity ETFs, the overall trend is positive. Since January, UK equity ETFs have gathered US$1.5 billion (10% growth) while European and euro equity segments have experienced outflows of more than US$9.5 billion. While not yet indicating a sizeable vote of confidence in UK assets, investors appear to have started to increase their exposure to UK equities and bonds’.

Figure 3: Cumulative flows into UK Equity & Bond ETFs domiciled in Europe, US$ million

Source: Bloomberg Finance L.P., as of 20 May 2016.

Navigating a remain vote with ETFs
In the event of a remain outcome on 23 June, UK equities could benefit from increased investor appetite. The FTSE UK All Shares Index, in particular, could be a beneficiary. A more diversified option than the FTSE 100 – it has over 600 stocks – it is also more domestically oriented because it comprises companies across the market?cap spectrum, not just the large caps. Domestically focused companies have been pricing at a slight discount compared with large caps, which often derive more than 50% of their sales from abroad. This discount could provide attractive opportunities.

As shown in Figure 4, the FTSE All Share’s performance has slightly trailed that of the MSCI World Index, offering potential scope for the All Share to improve on a relative basis.

Figure 4: Year?to?Date Cumulative Return, Local Currency

Source: Bloomberg Finance L.P., FTSE, MSCI, as of 20 May 2016.

From a European sector standpoint, European Financials could be worth considering. The sector is likely in our view to benefit from ECB policy activity announced in March and starting in June ? four new targeted longer?term refinancing operations to reinforce its accommodative monetary policy stance and to foster new lending. Our 4 April Bulletin assessed the prospects for this sector in more detail. Meanwhile as valuations of UK financials have been under pressure from uncertainty surrounding the outcome of the referendum, any positive sentiment that could follow a remain vote could benefit the sector in the short term. Since UK financials make up ca 31% of the MSCI Europe Financials index, they have a strong impact on movements in the index.

A UK vote to leave has the potential to surprise markets which could cause UK equities to fall in the immediate aftermath of the referendum. Such a scenario could have a knock on effect for European markets, where investors are already concerned about fragile economies and financial markets. The flight to quality that would likely follow could benefit UK gilts but it is more likely that US Treasuries would profit from their safe?haven status.

Investors wishing to position their portfolios for a remain outcome can obtain exposure to the potential upside in the FTSE All Share Index and European financials.

SPDR – EMEA ETF Strategy Team