June 24, 2016
By Steve Blumenthal
“Italeave, Finish, Czechout, Oustria, Byegium and Departugal.”
— Wilfred Frost, CNBC, June 24, 2016
For much of the past decade, Crispin Odey has been waiting for inflation to rear its ugly head. The fund manager has been positioned to take advantage of rising prices in his flagship hedge fund, the Odey European Fund, and has been trying to warn his investors about the risks of inflation through his annual Read More
Brexit! The world markets are in shock. What’s next? You’ll find my thinking below. This is day 1. There is more to come.
I’m en route to California where I’ll be leading a panel on portfolio construction at the Global Indexing & ETFs Conference early next week. It should be a lively conversation. I have to admit I’m feeling both unsettled and calm.
Long-time readers know I’ve been in the “it is time to play defense” camp. Two percent bond yields and 2-4% 10-year forward equity returns are just not going to cut it for you, for me, for pension plans, for insurance companies nor for the 75% of the capital that will be in the hands of pre-retirees and retirees by the year 2020.
Better to wait for the next significant correction to reset the playing deck. Until then, hedge that equity exposure, raise some cash to give you future buying flexibility and overweight to liquid strategies, such as tactical and managed futures, which have the potential to perform due to the unconstrained nature of their investment processes.
Logic and common sense must step to center stage. While levered long investments still need to unwind, fear not. There will be opportunities for those who have cash and wealth preserved in the days and weeks ahead.
So here we sit. A Brexit shock. Another snowflake? Does this one trip an avalanche or does it add one more layer of highly unstable snow? We just don’t know.
What is clear is that “We, the people” are pissed. I’m sure you, like me, are getting bombarded with Brexit commentary in your inbox. Following are our views on Brexit, a quick thought about the T-juncture and a link to this week’s Trade Signals.
This week’s OMR is a quick read. I hope you find it helpful.
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Included in this week’s On My Radar:
- Italeave, Finish, Czechout, Oustria, Byegium and Departugal
- T-Junction – Think About the Following
- Trade Signals – HY Opportunity Ahead (Just Not Quite Yet)
Italeave, Finish, Czechout, Oustria, Byegium and Departugal
We sent the following to our clients today: While it would be foolhardy to predict the details of what happens after the United Kingdom voted to leave the European Union, we wanted to address the potential impact of this unprecedented and historic vote. With global valuations already stretched and growth tepid and declining, the amount of uncertainty that the vote has brought into the market can have a significant impact and knock-on effect on financial markets and global politics. Below are our insights on what may come next.
Economic and Financial
The impact on financial markets has been startling. Currency markets have exhibited volatility not seen since the financial crisis and the collapse of Lehman Brothers. The British Pound has seen its largest one day drop ever and has hit its lowest level since 1985 against the dollar. European financial markets are down across the board, the Euro has weakened, the Yen and Dollar are higher against most global currencies and the Swiss central bank has intervened to prevent further appreciation in the Swiss Franc. The safety trade is on with U.S. Treasury bonds up sharply. Below are our thoughts on what may happen next:
- The Fed and US Interest Rates: The likelihood of a rate hike in September has declined precipitously and there are now predictions of a potential rate cut. As a result of the vote and the upcoming US election, it now appears highly probable that the Fed does not cut rates at all this year and bond yields are likely to remain lower for longer as a result. We remain in the rates will remain lower for longer camp.
- Risk of Recession: The UK is likely to fall into a recession and the risk of a US and global recession has increased. The EU accounts for approximately 50% of UK exports. We don’t see how this decision helps UK growth over the next several years while the UK and EU negotiate an exit. The big questions surround the UK’s status with respect to the EU common market and how subsequent trade agreements will be negotiated as well as the free movement of people (Norway can serve as a template). Further, the EU and specifically Germany loses a liberal economic ally and will now have less support for free market initiatives in the EU. Longer term, the UK is a major player in the world economy. They will negotiate, compete and do well.
- Greater Volatility: Much like the uncertainty surrounding Grexit over the past several years, we will likely see heightened levels of volatility in ebbs and flows for some time as details regarding Brexit are negotiated.
- This event is a major stress test on unconventional central bank policy.
- The title of this section suggests what we believe. There is more to come.
- United Kingdom: Today, United Kingdom looks a lot less “united”. Prime Minister David Cameron, who just last year secured the first Tory majority in 23 years, announced he intends to resign in October, a staggering defeat. Later this year, voters will determine who will lead the transition out of the EU. No one has any idea of who that person will be. Scotland is considering another vote to leave the UK in order to stay in the EU and there has been a call in Northern Ireland to leave the UK. In fact, the majority of votes to remain in the EU came from voters in Scotland, Northern Ireland and London. A UK without Scotland and Northern Ireland is a weaker UK.
- EU: In the short term, populist, anti-EU politicians stand to gain. Spain is set to have elections on Sunday and their two party system is likely to fragment while smaller parties gain power. It is not unreasonable to expect ideologically Eurosceptic candidates to harness the Brexit vote to stir voters. Immigration and the refugee crisis were key motivating factors for voters in the UK. Greek and Italian citizens will also be watching closely to see if the UK benefits from the exit. Longer term, if the impact of Brexit is negative for the UK, the EU could actually become stronger and more motivated to integrate if other member countries see what they stand to lose. Conversely, if the UK does well, it could spur other countries to consider their options. Politicians campaigning to leave the EU have promised voters control over immigration and a stronger economy. Now they have to deliver. Easier said than done.
- NATO and Russia: A fragmented EU will make discussions within NATO more difficult. It will be essential for the US, the EU and the UK to work constructively to insure that the NATO alliance is not weakened. Anytime European institutions are weakened, Putin and Russia stand to benefit. We believe they stay united
It is always difficult to deal with uncertainty. As humans, we don’t have the mental software to process these types of risks well. While we would all like to capitalize on market dislocations of this nature, few of us have the resources, conviction and speculator guts of George Soros to position significant wealth in highly targeted singular risks. We do however have an amazing set of tools in today’s world to manage risk better through broader, more holistic portfolio management. While we cannot predict the timing of such exogenous events, we can incorporate tactical strategies that raise cash and hedge equity investments, and include unconstrained bond and other non-correlating liquid alternatives in our portfolios to lessen the impact of chaotic events. We stand ready to assist you in deploying these risk diversifiers in your own portfolio and practice and are here to help you weather the strongest storms.
T-Junction – Think About the Following
Think about the following in relation to Brexit and political stability and cooperation. Heavy lifting needs to be done to soft land this debt deleveraging mess – both in the U.S. and abroad. The plane is coming in hot and the conditions are bumpy.
Read it and ask yourself which of Mohamed El-Erian’s views (below) are most probable:
“We are at a T-junction and the outcome is wide open, though I will not make a prediction because I simply don’t know,” he said. The primacy of central banks and the notion of a global economy at a crossroads are both themes of El-Erian’s recent book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.
El-Erian talked of optimistic and pessimistic views of the outcome:
The optimistic view hinges on three positives:
- Most economies know what’s needed—massive fiscal spending on infrastructure to stimulate the economy, even though there is a lack of political leadership to implement such policies
- The private sector is cash-rich and will start spending their cash on wages or capital expenditures
- Innovation that will disrupt the world of finance and how our economies operate
The pessimists will see the negative view that is equally valid:
- Politics are becoming really messy and may hinder the recovery by implementing disastrous policies (e.g., Brexit, Trump)
- Central banks will follow the Bank of Japan in becoming ineffective or counterproductive
- Financial assets have decoupled from fundamentals and heightened volatility will mean they will overshoot on the way up and undershoot on the way down, triggering an economic recession
“It has been nearly eight years since Lehman went under. If only we could congratulate ourselves for capitalizing on that misfortune for the betterment of the next generation of financial market firefighters. Instead, we stand on the precipice of God knows what, as central bankers’ grand experiment threatens to come undone wreaking havoc of wholly unforeseeable proportions.
– Danielle DiMartino Booth
Italeave, Finish, Czechout, Oustria, Byegium and Departugal… Brexit is just the beginning I’m afraid. Too much debt. Fractured structure. Zero currency flexibility for those that need it most.
International capital may fly quickly to U.S. stocks and bonds for money will always flow to where it is treated best, but the market is richly priced by most every historical measure. I’m not so comfortable taking the foreign capital flow equity bet.
Underweight and hedge that equity exposure, diversify, stay tactical and stay extremely alert. Significant opportunity remains in front of us. Let’s not get run over on the way.
Brexit is just the start. This is going to get very interesting. I think my friend Jim Rickards said it well earlier today:
“The problems don’t end there. What happened to markets as a result of the Brexit vote is not a one-time event. It’s a reflection of the following:
- Elites are out of touch with the everyday citizens.
- Experts are using obsolete models that produce erroneous forecasts and market losses.
- Central bankers are impotent since monetary solutions don’t solve structural problems.” Source: private newsletter.
I’ll be tweeting and posting to LinkedIn during the week. You can sign up to follow me here (Twitter/LinkedIn)
Trade Signals – HY Opportunity Ahead (Just Not Quite Yet)
Click through to find the most recent trade signals. My favorite weight of evidence indicator, The CMG NDR Large Cap Momentum Index, remains in a sell signal. Trades Signals is posted each Wednesday. Here is a link to the Trade Signals blog page.
Personal Note – California and Chicago
The 21st Annual Global Indexing & ETFs Conference is up next. I’m finishing this week’s letter from 36,000 feet somewhere over the Rocky Mountains. The wifi is slow but not too bad today. Mohamed El-Erian is the keynote speaker and I’m leading a panel on “Portfolio Construction Using ETFs.” Joining me at the conference are large institutional investors (endowments, foundations, pension funds), wealth advisors, ETF issuers, technology solutions providers and academics.
Our collective agenda, of course, is to explore opportunities for achieving superior investment performance through the utilization of an ever-expanding array of indexes and tradable index products. The growth and innovation of ETF products helps us all. I’ll share with you what I learn.
Chicago follows on July 20-22 for a large advisor client conference. August slows down. We just rented a beach house for the third week in August in Stone Harbor, New Jersey. I’ll be hitting Springers ice cream a bit too hard that week but hey… All the kids will be with us. Really looking forward to that downtime with my family.
In September, I’ll be speaking at the Morningstar ETF Conference about portfolio construction.
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Wishing you a wonderful weekend. I hope you too are planning to take some time off… and eat some ice cream.
With kind regards,
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman and CEO. Steve authors a free weekly e-letter entitled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.