ClearBridge Value Trust commentary for the second quarter ended June 30, 2016; titled, “Brexit And Market Risks: Real vs. Perceived”
“Then the unstable equilibrium generates a critical situation, which history has diversely met by legislation redistributing wealth or by revolution distributing poverty.” — Will & Ariel Durant
ClearBridge Value Trust – Brexit and Market Risks: Real vs. Perceived
Brexit surprised me, but not in the way you might think. What surprised me was the overwhelming flood of questions and concerns the final Brexit vote elicited from clients, colleagues, family members and friends across the political spectrum. With a few exceptions, they were all shocked by the scale of the potential risk and uncertainty inherent in such an abrupt policy change, and they were all looking for context and answers. I certainly tried to provide what context I could without the full benefit of time, but I personally was left with many more questions than answers. However, the core of my surprise is that I do NOT see Brexit as a dramatic departure from the risks and uncertainties that have dominated this market cycle: how do investors navigate a highly indebted world characterized by secularly challenged economic growth, monetary policy experimentation on an unprecedented scale and occasional bouts of deflationary tail risk? Isn’t Brexit just the latest vivid example of deflationary tail risk, or is it something more? To be sure, there is a fair amount of irreducible uncertainty related to all things macro and certainly Brexit, but there are always risks we can price through the discipline of valuation and subjective probabilities.
What Brexit did reinforce is that political and policy risks are extremely elevated. Simply, there are a lot of very angry voters in the world who feel ignored and excluded by the status quo and the creative destructive forces of global markets. From an angry voter’s perspective, the “elite” benefit from the global wealth creation of open markets, while the populist voter is left with destroyed manufacturing jobs. This gets to the heart of the Durant quote at the top of this letter, where wealth disparity leads to an “unstable equilibrium” that eventually elicits a direct redistributive policy response or broad wealth destruction through revolution. This populist signal was certainly amplified by the Brexit vote, and it will play a key role in the upcoming elections in the U.S. as well as several western European countries. The challenge for investors is that political risk is incredibly difficult to price, meaning it’s a real struggle to put an expected value on a political event through a quantifiable potential outcome and a subjective probability. This challenge was really driven home by the overwhelming confidence that got priced into betting markets and currency markets in favor of Bremain before the vote. Clearly, these London-centric markets did not price the risks well, most likely due to a lack of cognitive diversity that did not reflect populist sentiment outside the City. The key question, however, is what are the real enduring market risks from Brexit?
A key psychological wound that has been ever present since the financial crisis is that many investors have a heightened and constant awareness of “tail risk,” which is broadly defined as an extreme event that destroys risk capital by triggering a bear market in stocks, and cannot be modelled on a linear or normally distributed scale. Brexit clearly pulled this scab right off that wound, as people prepare for a deflationary impulse and possible global recession. We fully understand these concerns, but we believe there is a large gap between the perceived and real risks from a true “tail” event.
As referenced above, we think Brexit did not surprise markets with new risks but reinforced existing concerns that are already broadly priced across assets. This reinforcement manifested itself in a deflationary playbook that is now as well-known and executed as Vince Lombardi’s Packers Power Sweep: sell stocks, especially pro-cyclical and higher-price-volatility stocks, and hedge out this equity risk with bonds. As a result of this rinse-wash-repeat exercise, we are seeing modest elevation in already elevated equity risk premiums and valuation spreads, and continued explosion in negative-yielding sovereign debt, which has now reached a staggering $10.25 trillion globally, as seen below in Exhibit 1. Certainly, deflationary risks in this environment are very real, and we are anxiously watching for signs of Brexit contagion by monitoring credit spreads globally. However, this playbook is completely blind to value, as central banks, risk management priorities, and the increasingly powerful machinery of asset allocation and their favored passive vehicles are solving for one variable: low volatility. We believe periods of material misallocation of capital have historically happened when a dominant world view coalesced in extreme valuations and crowding, which potentially leads to a real tail risk.
Could bonds, primarily the negative-yielding sovereign variety, reach such an extreme level of valuation against historic norms that they quit rising or even fall? What would happen to risk management and asset allocation models if the negative correlation between bonds and stocks reversed? How much would yields have to rise if the crowd started to sell and a real value buyer had to provide a bid? How artificially elevated are all asset prices, including stocks and hard assets like real estate, by the historically low cost of capital? These questions make us uncomfortable, because it is a list of risks that we do not think are priced in, and if current trends reverse, it has all the markings of true tail risk: non-linear volatility and permanent losses of capital.
Of course, timing a reversal is a real challenge as you could have posed these same concerns over the last few years, and deflation and policy concerns are real fundamental risks that support low yields. Outside of simply collapsing under the weight of extreme over-valuation, however, there is a potential policy change that deserves close observation: we believe that monetary policy experimentation will now lead to fiscal policy experimentation. In the spirit of Charlie Munger’s “show me the incentive and I will show you the outcome,” what politician now fails to grasp the need to harness populist anger to get elected and stay elected? From this political perspective, it makes all the sense in the world to finance fiscal programs with record-low-yielding government debt, and we think populist sentiments are powerful catalysts to get fiscal programs underway as new administrations are elected in Britain and the U.S. over the next several months. If we are correct here, and fiscal experimentation helps to harness political power, fiscal policy changes could surprise us as much as current monetary policies would have been unimagined prior to the Great Financial Crisis. More explicitly, just as betting and currency markets blew the Brexit call, the lack of cognitive diversity in broader markets leaves us very wary of what potential outcomes are currently priced.
The key, of course, is how this wariness translates to explicit scenarios for the near to intermediate term and portfolio positioning.
- Perceived Tail Risk: