Brexit: Reading between the lines when UK PLC and the UK economy don’t match

Aug 22nd, 2017 | By | Category: ETF and Index News

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By Dr. Jan-Carl Plagge, Head of Research – STOXX

Brexit: Reading between the lines when UK PLC and the UK economy don’t match

Dr. Jan-Carl Plagge, Head of Research – STOXX

Recent political events such as the US and the French election were found to have had a major impact on stock markets. While the impact of such events may often be short-lived, Brexit will remain on the agenda as the country is negotiating its withdrawal from the European Union over the next two years. In this context, investors face a number of challenges when considering such political events in their portfolio management.

Firstly, one needs to have a view of how the political landscape will develop. This is often easier said than done as even economists and political experts analyzing developments and potential ramifications have conflicting views.

Secondly, investors have to understand how a scenario will impact local markets in the medium and long-term.

Thirdly, investors need to be mindful with regard to the investment vehicle used to translate their view and forecasted impact into action. Recent analyses show how new index concepts that take into account companies’ regional source of revenue generation provide a more precise investment vehicle in order to adequately capture the impact of key political and economic developments on equity prices.

Let us first take a step back and remind ourselves how country indices usually work: They select exchange listed companies domiciled in the respective country and typically weight them by a measure of market capitalization. While this has worked well for decades as a benchmark for the development of national economies, increasing globalization, which led to more interconnected markets, has significantly changed the landscape. With the rising internationalization of business, the share of revenues that many companies generate in their respective domestic market has been shrinking. This, in turn, leads to a reduction in correlations between the development of the companies and their home market. For example, global players such as Vodafone make less than one fifth of their revenues in the UK. To provide investors with a more accurate benchmark for the development of the respective domestic economy, STOXX has developed the STOXX True Exposure™ (STOXX TRU™) Indices that take into account the revenue exposure of each company to its domestic market in the selection and weighting process, focusing on companies that generate all or a significant portion of their revenue in targeted countries or regions. The advantage of this methodology for investors is getting a more focused representation of the targeted market and therefore being able to better diversify exposure of their portfolio to the macroeconomic development in select markets.

Overseas revenue appears as the key driver for UK stocks

The transformational implications of leaving the EU and the economic uncertainty they raise have, as expected, weighed heavily on parts of the UK equity market since the EU referendum in June 2016. The discrepancy of the reaction of UK equity prices to the referendum have caused many to have a closer look at single stocks rather than perceiving the UK equity market as a homogeneous cluster. A closer investigation of company characteristics reveals that the regional source of revenue generation was a key driver for the development of UK stocks, as a recent research paper highlighted. The analysis examines the performance of UK portfolios with a differing exposure to the UK market and concludes that the key driver behind this varied performance was the share of UK revenue for each company, partly translated via their relationship with the Sterling value. The STOXX TRU UK indices underlying this analysis group stocks by their level of sales generated domestically. Four different thresholds exist: 25%, 50%, 75% and 100% of sales derived from home. This offers investors a channel to secure genuine exposure to the British economy, rather than a globalized investment as is the case with traditional benchmarks such as the FTSE 100 Index, the STOXX® UK 50 Index and the STOXX® UK 180 Index. In general, the higher the index’s ties to the UK economy, the more negative the impact in the months following the referendum. The TRU UK 25% Index generated on average 70% of revenues domestically. Traditional UK benchmarks have a revenue exposure to the home economy of less than 40% (the STOXX UK 50 is around 30%). That explains their outperformance in the period following June 2016.

Brexit: Reading between the lines when UK PLC and the UK economy don’t match

The graph shows the performance of the four STOXX TRU UK indices plus the STOXX UK 50 and STOXX UK 180 indices since the EU referendum (Source: STOXX 22/6/2016 – 26/4/2017).

More opportunities to take tactical positions using STOXX TRU Indices

What this means practically is an investor that believed the UK economy would suffer from Brexit-related uncertainty, could have shorted the TRU UK 100% to seek additional returns or hedge an investment in standard country indices. The TRU UK 100% fell 11% between June 23 and Dec. 1. Not surprisingly, a correlation emerges between increased investor concern about the UK’s economic outlook, a weakening pound, and the performance of domestically-exposed companies. On the other hand, a weak pound boosts the revenues and competitiveness of companies that report in sterling and have high sales in foreign currencies. This relation led to the strong performance of standard UK large cap indices in the wake or the UK referendum. Hence, one may assume that these indices provide an adequate hedge against Brexit related uncertainly. However, investors need to be aware that these benchmarks provide them with implicit but significant exposure to foreign markets such as the United States. Hence, their regional exposure gets diluted.

Investors are increasingly targeting more focused strategies, enabled by an expanding body of data and smarter ways to process it. The STOXX TRU Indices are an example of the innovation and growing sophistication available in passive investment solutions. They present a vast array of opportunities to take advantage of the divergence in UK equity indices by implementing investment strategies – including long and short positions. As expectations will sway in coming months between the possibilities of a ‘hard’ or ‘soft’ Brexit, the STOXX TRU UK could be efficient proxies to capture that sentiment.

Reading between the lines how UK PLC and the UK economy match will be essential to optimize portfolios to the different Brexit scenarios – with the STOXX TRU Indices investors are now well equipped to find accurate benchmarks to do so.

Please find more details on the analysis in the research paper published by STOXX

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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