Leumi Investment Services letter for the third quarter ended June 30, 2016; titled, “Brexit – A Globalization Referendum.”

Leumi Investment Services: Brexit – A Globalization Referendum

The events of late June upended the complacency in markets that characterized most of the second quarter of 2016, though you would never know it by looking at quarter-end data. There is a principle in mathematics called “path independence” in which only an outcome matters, which is not reliant on any process to get there. So comparing, say, the FTSE 100 at June 30th (6,504) in the chart below vs. year-end 2015 (6,242), one might conclude all is well; with a 4.2% half-year increase the trajectory it took does not matter.

Leumi Investment Services Brexit

But don’t tell that to those who lived it. The unexpected vote by the UK population to leave the EU on June 23rd likely introduced a multi-year period of uncertainty and volatility for global markets.1 We review below the immediate response to Brexit, and make the case that it is, in fact, “path dependent,” linked to a number of events in recent years that point away from globalization and toward international disengagement. Further, the reduction in international commitments does not just apply to the UK, but represents a phenomenon that is happening across regions. We examine the likely response by central banks and conclude with recommendations for client portfolios.

1. Brexit – Immediate Market Response

More on path dependence below, but we do want to highlight the quick down trade and forceful recovery of the equity markets after the votes were tallied. In our view, the low odds given to a Brexit win means that its potential negative effects were not priced into the market prior to the vote (see chart above). That explains the dip. The quick recovery thus suggests that either the market had been oversold regardless, or that the market currently misgauges the potential global effects to come in the form of lower trade and suppressed growth.

Note in our chart below, “Key Market Performance Indicators – Equities” that the European, Japanese and Chinese markets experienced a downswing over the first half of the year, while the US and UK markets were up over the same period (Brazil, too, has rallied as the market holds out hope for better governance and economic management under the Temer administration). The figures on the right two columns of the chart (green highlights) show market performance through June 23rd, followed by the markets’ performance in just the final week of the quarter, after the post-Brexit plunge of June 24th. Notably, equities found a quick rebound following the sharp selloff immediately after the Brexit vote.

Leumi Investment Services Brexit

The Price-to-Earnings (P/E) ratios of the major markets continue to reflect comparative economic growth, with the US and UK expanding, and Europe, Japan and China relatively flat. As noted above, Brazil forms an outlier and investors in Bovespa companies anticipate a recovery from the deepest recession in Brazil since the 1930s (see chart below).

Leumi Investment Services Brexit

In the fixed income markets, yields hit historical lows after the Brexit vote as a flight to quality sent investors into safe-haven US Treasury bonds, as well as gold and sovereign bonds in Germany and Japan, where yields ended the quarter in negative territory (see “Key Market Performance Indicators – Fixed Income”, below). While persistent low interest rates have troubled US investors positioned for income producing assets in conservative portfolios, we note that many offshore investors have it worse with negative rates in the Eurozone and Japan. We have heard anecdotally of such investors buying US municipal bonds and foregoing any taxes withheld. They still come out ahead yield-wise relative to their home country options.

Leumi Investment Services Brexit

2. Brexit as a Referendum on Globalization

We see signs of a nascent realignment of the seemingly inevitable march of globalization, with a swing of the pendulum back toward protectionism and a focus on domestic issues in many countries. The Brexit vote represents the largest move thus far in what appears to be a generational shift toward insularity and away from global integration. Globalization is under attack in general, and in Europe in particular. Reactions to the recent immigration crisis that has unfolded there have heightened tensions and given voice to formerly fringe political parties and their leaders. The will of the people in these mature democracies is being heard, and after Brexit many elsewhere are calling for similar referendums on the EU.

Underpinnings of a Pendulum Shift

“The globalization of the economy has benefited countries that took advantage of it by seeking new markets for their exports and by welcoming foreign investment….But for millions of people globalization has not worked. May have actually been made worse off, as they have seen their jobs destroyed and their lives become more insecure. They have felt increasingly powerless against forces beyond their control. They have seen their democracies undermined, their cultures eroded.”

In the quote above, from his 2002 book Globalization and its Discontents, Joseph Stiglitz was writing about populations in emerging markets. Large-scale demonstrations against economic globalization and the “Washington Consensus” on IMF stabilization programs began in the late 1990s, as the negative effects of the “contagion” resulting from increasing interdependence rolled through financial crises in Mexico (1995), Southeast Asia (1997), Russia (1998), and Argentina (2001), among others. Today it is becoming clear that Stiglitz’s observations apply equally to the UK population who voted to leave the EU, to French citizens who support the National Front’s anti-immigration platform of Marine Le Pen (“Today Brexit, Next Frexit”), and to a large number of US voters in “flyover” states who expressed their dissatisfaction with the status quo in Washington through this year’s party primaries.

Path Dependence and the Brexit Vote

The “path dependence” theory in economics holds that nothing happens without antecedents, without some history leading up to it. Taken in this perspective, the Brexit vote should perhaps not have been such a surprise. While it does amount to a large shock for the UK, the main effect it is expected to introduce – a realignment of the UK’s trading arrangements with the EU – seem almost inevitable in light of the growing level of trade restrictions taken not only by the UK but also other countries in the Group of 20 (G20).

In its “Report on G20 Trade Measures” released June 21st, the World Trade Organization (WTO) noted that the level of trade-restrictive measures taken by G20 countries had reached the highest level since it began tracking them in 2008. The stockpile of such restrictive measures (net of those removed) reached nearly 1,200 by May 2016, compared to about 320 in 2010 (see chart below). In addition, the pace of new trade-restrictive measures reached a new high at 21 per month, or 145 over the six months leading to mid-May 2016. These measures involve some 5% of global imports.

Leumi Investment Services Brexit

By another measure, trade growth compared to GDP growth is more startling: over the 1990-2008 period

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