Brexit Optimism Fizzles as Cost of FTSE 100 Hedges Inflates

Updated on
  • U.K. stocks, near records, trade at premium to region’s shares
  • JPMorgan lowered its rating to neutral from overweight

As U.K. stocks hover near all-time highs, the optimism that took them there is starting to fade.

Investors are paying the most since early June to hedge against swings in the benchmark FTSE 100 Index relative to the regional Euro Stoxx 50 Index. The U.K. gauge, up 12 percent this year thanks to a slumping pound, has been hovering around 7,000 for most of the month, though it failed to maintain a record reached intraday on Oct. 11. It slipped 0.5 percent at 8:29 a.m. in London.

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Traders are beginning to speculate on the form that Brexit will take, looking beyond the initial boost of a falling currency. Confidence in economic data, which surprised by how much they beat forecasts following the secession vote, is now giving way to inflation concerns, while economists are calling for the slowest quarterly expansion since 2012. JPMorgan Chase & Co. lowered its rating on U.K. shares this week, recommending instead to buy euro-area stocks.

“Valuations became extremely stretched,” said Leigh Himsworth, who manages about $91 million of U.K. equities at Fidelity International in London. “When it comes to the economy, the reality of Brexit is really starting to kick in, and inflation is just one example of that. Nobody really knows what can happen. Investors need to work a lot harder to finds pockets of value.”

As the pound tumbled to levels not seen since 1985, analysts estimated the FTSE 100 would benefit as its members get most of their revenue from abroad. They project company profits will slip just 0.8 percent this year, compared with a 8.5 percent contraction seen in June.

But, since the index rallied to a record, strategists have begun saying the gains have gone too far. They’re calling for a 4.8 percent decline in the FTSE 100 from Tuesday’s close through the rest of the year, according to the average of nine forecasts compiled by Bloomberg.

QuickTake Brexit

JPMorgan, among the first to turn bullish on U.K. equities back in February, has cut its rating to neutral from overweight. The firm says investors may take any further drop in sterling negatively if politics become more uncertain, while an acceleration of inflation could hurt consumer stocks. With earnings expectations for British companies leaving little room for positive surprises, it’s time to switch to euro-area equities, down 5.5 percent this year, the bank said in an Oct. 24 note.

As Prime Minister Theresa May prepares to start negotiations to leave the European Union, speculation has increased that by severing most ties to the common bloc, Britain will suffer. While data have stood up to the Brexit blow, a Bloomberg gauge tracking the degree to which the figures beat or miss forecasts has dropped to its lowest level since before the referendum.

Economists forecast gross domestic product expanded 0.2 percent in the third quarter from 0.7 percent in the previous three months. That would mark a bigger slowdown than for any of Europe’s major economies and compares with the growth rate projected for Greece. And yet, even gauges of British mid- and small-cap shares reached record highs this month.

The surge in the FTSE 100 pushed it to one of the best performances among developed markets this year, lifting its valuation to about 15 times estimated earnings, or 12 percent more than the multiple for the Euro Stoxx 50.

But since mid-August, the cost of options on the British index has climbed 15 percent, while that of contracts on the European gauge has slipped, according to 30-day implied volatility data compiled by Bloomberg. Almost 44,000 bearish puts changed hands each day on average this month, the most since December 2014 and almost double the number of calls.

“There is a 100 percent chance of leaving the European Union, and the FTSE valuation does not reflect that probability of a negative event,” said Ben Kumar, London-based investment manager at Seven Investment Management, which oversees about 10 billion pounds ($12 billion). “Europe has a lot further to bounce back.”