Okay, I’ll admit it: on the morning of the Brexit result I was a worried man.
Of course I was! I’m the editor of The Penny Share Letter, a newsletter which analyses and recommends small company shares. And the markets were reeling.
It’s not just that the pound crashed, along with UK stocks. There were big falls in Europe, Asia… even the Mexican peso took a dive.
It was starting to look like the UK was at the centre of a global collapse… a black hole of debt and chaos and disorder, sucking in the entire world economy…
Well, it’s been two months now. And so far, there’s no sign of the collapse of the British economy (touch wood).
In fact, things are starting to look pretty good for UK small cap investors…
A couple of companies tell the story of Brexit and its aftermath.
After the referendum result British banks and British property businesses were in the eye of the storm. Barclays lost about a third of its value overnight. The housebuilder Persimmon (not to mention a small cap housebuilder in the Penny Share Letter portfolio) also took big hits.
Why did those businesses take Brexit the hardest? Well, it was speculated that Britain’s domestic economy would suffer as a result of Brexit. UK banks and property businesses are heavily dependent on the domestic economy. So they got it in the neck.
Check it out – the following chart shows Barclays’ share price after the result was announced.
Since the result we’ve had two months of economic data. And on the whole, it’s showing that the economy is pretty stable. The worry was that fearful Brits would all stop spending their money at the same time, leading to what’s called a demand side recession, or a monetary recession.
Here’s how I described a demand side recession directly after the result:
“A monetary shock happens when people stop spending money. When lots of people get frightened at the same time they want to hold cash, which is the safest asset. That increases the demand for money.
An increased demand for money has the same effect as a reduced supply of money. It slows the economy down. And if enough people do it, it crashes the economy. The Great Depression in the 1930s, Japan’s “lost decade” in the 1990s and the financial crisis in 2008 are examples of monetary shocks.”
Basically, this hasn’t come to pass. Brits seem to be spending their money – in July, they spent more at the shops than any July since 2002. That’s up 5.9% on the previous year.
The dreaded demand-side recession might yet show up. We don’t know for certain whether people are delaying buying houses, for example. And the July spending boom could be driven by foreign tourists cashing in on the cheaper pound. But the news so far has been encouraging – witness Barclays’ share price in the two months since the vote.
The wind at their backs
In fact, the whole Brexit drama is proving to be a net benefit to lots of small cap stocks. That’s because it scared the Bank of England enough to create more money (ie, to cut interest rates). And lower interest rates stimulate the economy.
Here’s what I said about the central bank’s response to Brexit at the time:
“The thing is that… monetary shocks can be solved fairly easily. They happen when there’s extra demand for base money. If the central bank creates base money, the system balances itself out, everyone chills out and the demand for money goes back to normal.”
No one can really say whether the Bank of England’s rate cut is what caused everyone to “chill out”. But it surely helped. And it’s surely one of the reasons why small cap stocks have been on a tear in the last few weeks.
Small caps at an all time high
The FTSE Small Cap Ex Investment Trusts index, which is made up of UK small cap stocks, hit a record high this week. It’s up 4.1% since Brexit.
Around half of those companies sales came from outside the UK – which rather neatly matches the make up of my Penny Share Letter portfolio. Companies with overseas earnings will have benefited from a falling pound. And companies with mostly domestic earnings will be relieved by strong economic data as of late.
I’m seeing the exact same thing coming through in the Penny Share Letter portfolio. The most recent trading updates from UK focused businesses have been very positive. And the companies’ share prices are on a tear.
It’s one of those times where I’m happy to be wrong.