Market Extra: U.K. stocks turn Brexit into boost, on track for best quarter since 2013

Brexit, what Brexit?

In the first full calendar quarter that followed the U.K.’s vote to leave the European Union, the country’s benchmark stock index is set to bang out its best quarterly performance in more than three years, defying fears of a stock market meltdown.

With only one trading day left in the quarter, the FTSE 100 index UKX, -0.88%  is up 5.4% for the period, marking its best three-month climb since March 2013. In comparison, the pan-European Stoxx Europe 600 index SXXP, -0.96%  is up 2.9%, while the U.S. benchmark S&P 500 index SXP, +1.21%  is eyeing a 2.5% third-quarter advance.

“A lot of investors were very shocked after Brexit and worried about the effect on U.K. activity, but interestingly enough the FTSE 100 is not fully reflecting the U.K. economy. The FTSE 250 is much more driven by domestic developments,” said Emmanuel Cau, global equity strategist at J.P. Morgan.

“There was an initial shock in the market, but the falling currency ended up being a big positive for the FTSE,” he added.

The pound has slumped more than 10% against other major currencies following the June 23 vote, giving U.K. companies that make a large chunk of their earnings overseas an unexpected boost.

About 75% of revenue for the FTSE 100 are generated outside the U.K. from large international companies such as AstraZeneca PLC AZN, -1.29% AZN, -2.28% British American Tobacco PLC BATS, -0.12% BTI, -1.08%  and Associated British Food PLC ABF, -1.57%

Several companies, including ABF and Burberry PLC BRBY, +0.96% BURBY, -4.04% have already lifted their 2016 profit expectations because of the weak sterling post the Brexit vote.

The FTSE 250 index MCX, -0.94%  , which is made up of smaller, more U.K.-exposed companies, dropped sharply in the immediate aftermath of the EU referendum, but rebounded in the third quarter. The benchmark was on track for an 8.8% jump for the period.

Only game in town

But there’s more to the FTSE’s strong quarter than the currency story. Aggressive monetary easing from the Bank of England, ultralow global bond yields and a rebound in commodity prices and emerging markets have together formed the perfect base for a stock rally, analysts said.

“There’s nothing whatsoever in the so-called Brexit uncertainty that would deter me from investing in the stock market. Look at the dividend yield on the FTSE, it’s about 4%. In a low interest-rate world that’s a fairly decent return” said Michael Hewson, chief market analyst at CMC Markets.

“When you look at the spread between gilts and equities, ultimately equities are the only game in town,” he said. Gilts are U.K. government bonds.

Yields on 10-year U.K. government bonds TMBMKGB-10Y, -5.23%  plunged to record lows during the quarter, after the U.K. central bank announced plans to restarts its asset-purchase program in a bid to weather any Brexit-related weakness. The bank also said it would start buying corporate bonds, sending yields on such papers to all-time lows.

FTSE ‘ticks all the boxes’

The big question for the FTSE now is whether it can keep the upper hand and continue to rally in the fourth quarter and 2017.

“Yes, we think so,” said Cau from J.P. Morgan said. “It’s cheap and underowned. We think earnings will grow next year because of the [currency] weakness and the commodity composition and to some extent this is the kind of market that should perform well if bond yields stay as low as they are now.”

“The U.K. market ticks all the boxes,” he said.

Cau struck a particularly upbeat tone on the U.K.’s energy companies, forecasting double-digit earnings growth for the sector next year. That’s partly because they come from a low base, and partly because of the recent rebound in oil prices.

The FTSE 100 is heavily skewed toward the commodity sector, so the fortunes of oil and metals tend to drive the market’s performance. Crude oil CLX6, -0.36%  is up 29% so far in 2016, and was given a 5.3% boost on Wednesday when the Organization of the Petroleum Exporting Countries, in a surprise move, announced a plan to cut production.

However, investors are skeptical the plan—yet to be completed at the cartel’s November meeting—will actually be carried out by the member states that have been aggressively competing for market share.

“But I think it is definitely a step in the right direction that this supply issue is being addressed. That might help oil prices rise on the short term and help the oil companies in the U.K. market,” Cau said.

The oil rally earlier this week helped the FTSE close at a six-week high on Thursday at 6,919.42. The benchmark, however, slumped 0.9% on Friday as mounting fears over Deutsche Bank DBK, -4.55% DBK, +3.17% DB, -6.67%  financial health spread to the U.K. banking sector.

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