The surprise ‘leave’ result following the UK referendum on EU membership was a shock to markets, which were to an extent wrong-footed by exit polls and bookies’ odds strongly in favour of a ‘remain’ outcome. The binary nature of the referendum has meant that a sharp movement upwards or downwards was always to be expected. The bigger shock to markets has been the curious political situation the UK finds itself in which seems to suggest the result took the government and key players of the ‘Vote Leave’ campaign by surprise too. At the time of writing, the Prime Minister has resigned, the front-runner to succeed him has pulled out of the race and Labour MPs overwhelmingly voted in favour of a vote of no confidence in their leader. As a consequence, there is no clear picture developing around how our relationship with Europe will proceed going forward. The risk is that political instability will breed uncertainty and hurt corporate and consumer confidence. At this early stage, the impact on the economy remains to be seen, and we expect little clarity until economic data is released at the end of July. However, lower levels of activity in the summer will likely serve to distort the true picture, so corporates and investors may be flying blind for quite some time.
Putting things in context: with world banks share prices falling 11% in the two days following the referendum vote - considerably more than following the collapse of Lehman’s brothers – some commentators are trying to draw comparisons to the global financial crisis. We would discourage from drawing such parallels and believe that this is a localised issue. The Governor of the Bank of England has reassured markets that a plan is in place to provide liquidity and support and has also directly stated that UK banks are better capitalised and therefore equipped to deal with any future shocks. Encouragingly credit markets have held up relatively well in comparison to the global financial crisis, as illustrated by the credit default swaps (CDS) market where the cost of insuring loses against bonds hasn’t become materially more expensive. Furthermore, the muted reaction of North American CDS market support our view that this issue is contained to the UK and Europe, at least for the time being.
UK Equities have been mixed. At time of writing the FTSE 100 is up +3.81% since the eve of 23 June 2016, while the FTSE 250 index is down -4.92% and the Numis Smaller Companies ex. Investment Trusts Index (the benchmark of Henderson Smaller Companies Investment Trust) is down -5.9%. The divergence in fortunes is reflective of the fact that the FTSE 100 is a large cap international index whilst the FTSE 250 and Numis Smaller Companies index better reflects the UK economy and includes more UK domestic stocks.
In the months leading into the referendum vote, trading and new investments in the Henderson Smaller Companies Trust were focused on long-term, structural growth stories where the investment case did not rely on what was going on with the broader macroeconomic environment. However, the domestic bias of our portfolio did not leave us immune to the Brexit aftermath. Our response to the newsflow has been to reduce the Trust’s gearing (borrowings), primarily through the sale of UK domestic stocks. Selling has not been indiscriminate. For instance, the extreme mark down of UK housebuilding stocks feels inconsistent with the underlying investment case: they have strong balance sheets, there’s a lack of a supply in housing nationwide, the government is broadly supportive and the banking sector looks healthy. As such we have retained these positions. Furthermore, we will continue to focus on stock picking and use the current market rout to exploit the opportunities Brexit has presented us with.