There Is Method Behind The Markets Madness

It's been another brutal day on markets with both sterling and UK equities coming in for a drubbing but gilts – UK government bonds – being sought for their safe haven qualities.

Yet the selling has been far from indiscriminate.

It is worth noting that the FTSE 100, while currently trading 2% lower, has held onto the 6,000 level for most of today and actually stands above the 5,950 level at which it stood when, in February, the Prime Minister called the referendum.

Since the beginning of the year, it is only down by 3.7%.

Behind that headline level, though, there are plenty of movers.

The banks have been thumped because investors are now assuming there will be a recession.

That will mean a hit to profits as loan quality deteriorates.

Another cut in interest rates, which could come as early as July, would further depress net interest rate margins, the difference between the amount banks charge borrowers and pay to savers, further hitting profits.

And there are also concerns that ‘passporting’, the regime allowing financial institutions to trade across the EU without having to go to local regulators for permission, may also be vulnerable.

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That has further rattled confidence in the banks although it is largely only Barclays (LSE: BARC.L - news) and HSBC of the UK banks that enjoy major benefits from the regime.

The sell-off in Royal Bank of Scotland (LSE: RBS.L - news) has been especially aggressive.

It is now back to levels last seen in January 2009 when, at the height of the financial crisis, it was effectively nationalised.

The second sector that has been pummelled, for a second day running, is the housebuilders.

They, too, are the victims of investors pricing in a recession and a likely fall in house prices.

Quality companies like Berkeley Group (down 27% during the last week), Barratt Developments (LSE: BDEV.L - news) (down 35%) and Persimmon (down 39%) have all been hit by seemingly indiscriminate selling.

Longer term, there will all be concerns about the ability of the housebuilders to plug any skills gaps created by the loss of workers from the EU, since freedom of movement looks likely to be a casualty of Brexit.

Stocks connected to the housing market have also been battered, including the builders merchants Travis Perkins (LSE: TPK.L - news) and Foxtons, the estate agency, which issued a profits warning this morning.

The third sector to have been thumped are those companies exposed to consumer spending which, with a recession forecast, are also expected to suffer a downturn in profitability.

EasyJet (Other OTC: EJTTF - news) and International Airlines Group, the owner of British Airways, have both issued profits warnings since the referendum, with concerns not just about future earnings, but also that they may face complex regulatory issues following Brexit.

Other consumer-facing stocks that have been hit hard include ITV (LSE: ITV.L - news) and Whitbread (LSE: WTB.L - news) , the owner of Costa Coffee.

Yet there have also been some gainers.

With (Other OTC: WWTH - news) sterling having fallen so hard, those companies who derive a large amount of their earnings in US dollars have actually seen their share price rise today, as a stronger dollar boosts earnings.

So the likes of Diageo (LSE: DGE.L - news) , Unilever (NYSE: UL - news) and British American Tobacco have all traded strongly today.

So too have the likes of Randgold Resources, a gold producer, whose earnings may be boosted on the back of the rising gold price.

Another blue-chip that, to date, has been relatively unscathed is Vodafone.

Its shares are marginally lower today but higher than they were this time last week – because, post-Brexit, some investors are betting it will not be subjected to the tough new regulations brought in by the European Commission to bring down the cost of roaming.

More striking still has been the sell-off in the FTSE 250, the FTSE 100's little brother.

Unlike the Footsie, it has fewer international stocks and more domestic ones, so has been hit harder than the premier index.

Its fall of 7.19% on Friday was its biggest one-day fall since ‘Black Monday’ in October 1987 and it has fallen by an additional 6.1% today.

If there is one crumb of comfort for the market, it is that George Osborne effectively ruled out holding any kind of emergency budget until after there has been a leadership contest in the ruling Conservative Party, with expectations running high that the Chancellor – whoever that may be after a new Prime Minister has taken office – may have to roll back on austerity and instead go for more pump-priming.

As for sterling, after the rally that it staged on Friday afternoon, normal service has been resumed.

The pound, which was trading at $1.50 at 11pm on Thursday evening when it looked as if the ‘Remain’ campaign had won, came rattling all the way back to $1.32 at 5am on Friday morning.

It then hauled itself up to test the $1.40 level on Friday afternoon before settling down at around $1.36 going into the weekend.

This morning, however, it traded below $1.32 for the first time since 1985 amid expectations of an interest rate cut and, potentially, more quantitative easing.

These are dramatic moves by the standards of the foreign exchange markets – sterling has not traded below $1.40 for a protracted period of time during the last three decades.

The bigger question, perhaps, is how businesses respond to this devaluation.

Previous devaluations have tended to be treated by companies as a windfall, with the boost to profit margins being handed back to shareholders, rather than being recycled back into the business to boost productivity – one of the UK’s long-running economic weaknesses.

The other market where there has been drama since the referendum is in gilts, or UK government bonds.

The price of these has risen, as they are seen as a safe haven, although this is somewhat paradoxical in some ways because several of the major credit ratings agencies have downgraded the UK’s creditworthiness.

All other things being equal, this might normally be expected to make gilts less attractive to investors, as any ratings cut casts down on the UK’s ability to meet the interest payments on its debts.

As the price of bonds rise, the yield on them conversely falls, with the upshot that the yield on 10-year UK gilts today fell below 1% for the first time in history.

The impact of this, of course, is to reduce the cost of borrowing for the UK government.

If the incoming Chancellor does decide to tear up Mr Osborne’s plans and turn on the spending taps – on the basis that shoring up an economy in recession is more important than bringing down government borrowing – this fall in borrowing costs will certainly make it easier to do so.

It’s also worth bearing in mind that this is a markets crisis that goes beyond the UK.

The French and German stock markets have both fallen by more than Britain’s during the last two days because Brexit is seen as having the potential to drag down the entire eurozone economy.

Among the biggest fallers have been the Italian banks because the Italian economy is seen as especially vulnerable and because, unlike other banks in the eurozone, they have yet to make full provisions for loans on their books that have soured.

There is now speculation that Rome could even come up with capital injections for the Italian banks.

Unfortunately, this chaos looks set to run for some time, at least until a new Prime Minister has entered office and more clarity has emerged concerning Britain’s relationship with Europe after Brexit.

That clarity may take many months, though, to emerge.