Mind the gap!

Brexit
Those of you visiting London and using the underground will no doubt have heard the warning ‘Mind the gap!’ when alighting the tube train at the Bank or other underground stations. Which got us thinking.

With all the current market volatility, we are constantly having to ‘Mind the gap!’ This is the difference in valuation across global equity markets. Within the UK, there is then also the valuation gap to consider between the various segments of the market from large multi-national companies in the FTSE 100, to FTSE 250 mid-cap companies and to FTSE Small companies and those on AIM. Which offers the most attractive relative valuation and more importantly are the forecasts on which these are based realistic? A share price could look very cheap but prove not to be, if the profit forecasts in the market are wrong!

The FTSE 100 has been depressed due to its exposure global mining and oil whereas the UK mid and small cap indices are typically much more focused on the UK domestic economy and consumer spending. Whereas lower fuel and energy prices, benign food prices, a solid house market and improving employment and wages are highly supportive of UK domestic companies. However, care is needed as some companies have had to contend with un-seasonally mild and very wet winter weather as well as the imposition of the National Living Wage.

Talking of ‘mind the gap’, the other one that we are watching is 20.6 miles wide, known as the English Channel and separates the UK from Europe. We discuss the forthcoming BREXIT vote below. David Cameron and European Council President Donald Tusk, are currently locked in negotiations on the UKs EU position.

What have we been watching?

Stock markets generally had another strong week in spite of ongoing volatility in the oil price and Chinese equities.

Reports of record Iraqi oil output led to a 6% drop in West Texas crude oil at one point to $28 before recovering 25% on supply cut rumours which no doubt prompted hedge funds to close some short positions adding to the spike. The Chinese equity market had yet another wobble, dropping over 6% after reports that equity outflows from the country reached a record $1trillion in 2015.

Global investors have also been watching the start of the current US companies reporting season for clues to the economic outlook, although the disappointments so far have tended to be company specific or a consequence of the industrial sector exposed to the collapse in oil prices. The US Fed also slightly disappointed some US investors in not expressing any need to change its current interest rate strategy given recent stock market volatility and its potential impact on the US economy. Basically it maintains a watching brief. The week ended with news of action by another central bank with Japan moving to negative interest rates. The message that central bankers ‘have got our backs covered’ helped rally equities.


China Flag
Markets remain fixated on China and the challenge of moving the renminbi from a US Dollar peg to a free float, while also managing soft landing for the world’s second largest economy. The drop in China’s foreign exchange reserve in December of $108bn no doubt came as a shock to the authorities. Having recently earned the renminbi IMF recognition as an official reserve currency, China has sought to use its reserves to support the renminbi but this has been a costly process, they have burned a lot of reserves while there has been stock market volatility. The governor of the Bank of Japan has suggested that capital controls could prove useful to Beijing. The PBoC has cut interest rates six times since the end of 2014 but further cuts could create more weakness, and it has to find ways to pump more money into the economy to counter the monetary contraction caused by capital outflows. In the meantime, economic data continues to look soft with Chinese industrial profits declining for the seventh month in a row which is likely to overshadow the outlook for business investment.


Europe
In Europe, the BREXIT issue is also beginning to gain more coverage adding to the uncertainty for the UK. The main concern according to some of the major global investment banks appears to be the fact that the UK’s Current Account deficit is funded by capital flowing into the UK. Overseas investors own at least 25% of UK Gilts and more than 50% of London’s non-residential property. The UK has the largest twin deficit in the developed world at 8% of GDP and a 3.6% current account deficit. They argue that if the UK were to vote to leave Europe, then UK assets, in the eyes of overseas investors, would require a higher risk premium to be attractive leading to a fall in Sterling. This in turn could create inflationary pressures and damage business confidence. More disturbingly for global investors, BREXIT could then set off a ticking time bomb in other disillusioned parts of Europe and Euro weakness. Some have suggested that if the Eurozone were then to implode that the UK could then be seen as a relatively safe haven.


British Flag
BoE Governor Mark Carney appearing before the Treasury Select Committee ducked questions that sought his view on the BREXIT issue, as the BoE must be seen to remain politically neutral at this stage. However, he warned of financial instability, higher interest rates and capital flight. David Cameron will only set a firm date when confident of the right outcome, but 23rd June 2016 is rumoured and seems, like last year’s Scottish independence vote, as if it will create considerable uncertainty. Companies with sizeable UK and European operations are no doubt having to devote resources to ‘what if’ planning which is also likely to add to the uncertainty.

However, while negative for global investor sentiment towards the UK, Sterling weakness would be helpful to many British manufacturers and exporters providing a tailwind to profits. For example, within the FTSE 100 it is estimated only about 20% of earnings are derived from the UK. Against this those UK companies which import goods, such as the retailers could face currency headwinds.

The UK economy grew by 0.5% in Q4 2015, taking the annual rate of growth to 2.2% albeit down on the 2.9% growth achieved in 2014. The UK economy remains unbalanced with weaker construction and manufacturing growth, prompting concerns that the reliance on the services sector is increasing further.


Europe
Elsewhere in Europe was it a flight to safety or the thought of possibly more QE? German 5 year Bund yields dropped to a record low of minus 0.24%. Germany lowered its 2016 economic growth forecast from 1.8% to 1.7%, given the weakness of emerging market exports for its manufacturing sector.


USA Flag
In the USA, consumer confidence picked up to a three month high in January. This would suggest that the Q4 slowdown in consumption was temporary as this level of consumer confidence is consistent with consumer spending growth of nearer 3%. US home sales hit a ten month high in December. The US Fed did not appear to be concerned about the impact of recent global stock market volatility on the US economy, preferring to stick to its monetary tightening policy. This would suggest that the US Fed must be more confident about the resilience of the US economy than US investors. The US manufacturing sector would also probably not agree given US durable (long lasting) goods orders dropped in December.


Japan Flag
In Japan, the BoJ moved to negative interest rates in an attempt to make Japanese banks lend, rather than leaving cash on deposit.


Oil Drum
Oil dropped after news that Iraq was pumping more oil, before surging from under $28 to $35 on rumours that the Russian oil minister was willing to discuss production cuts with OPEC at a meeting next month. However, there has been no confirmation from key member Saudi Arabia while Kuwait’s OPEC governor said that he did not see oil prices recovering until after 2016 and that they would then be likely to settle between $40 and $60 a barrel until 2020.


Finally, ‘Creed’ the seventh film in the Rocky series featuring Sylvester Stallone as the retired boxer Rocky Balboa has gone on release in the UK. Coming into work at the moment feels a little bit like being in a boxing ring. We are having to be nimble on our feet, duck and dive and keep our gloves up to avoid the constant blows that seem to be raining down! Which reminded us of the time that Frank Bruno, when fighting Mike Tyson, asked commentator Harry Carpenter ‘Where’s my stool, Harry?’ ‘You’re sitting on it’ he replied ’Thanks, I thought he’d hit me with it!’


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