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.
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.
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).
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.
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.
By another measure, trade growth compared to GDP growth is more startling: over the 1990-2008 period merchandise trade grew 2.1x as fast as GDP on average. Yet since 2008, trade growth has scarcely kept up with GDP (the last time this happened was in the 1980-85 period), at less than 3% per year. WTO Director General Roberto Azevedo points out the effects succinctly in announcing the June report: “These trade-restrictive measures, combined with a notable rise in anti-trade rhetoric, could have a further chilling effect on trade flows, with knock-on effects for economic growth and job creation.”
Brexit – Gauging the Future Path
In the short period since the Brexit vote, we have begun to see the battle lines forming in what we expect to become a prolonged process that accelerates and decelerates, intensifies and relaxes, pushes the VIX risk indicator up and allows it to float back down, with little centralized direction.
The issues at stake go to the very core of globalization. Back in 2004, Jagdish Bhagwati wrote in his book, In Defense of Globalization, “Economic globalization constitutes integration of national economies into the international economy through trade, direct foreign investment (by corporations and multinationals), short-term capital flows, international flows of workers and humanity generally, and flows of technology.” These ideas embody the core principles of the EU, and sit at the crux of the discontent that Brexiteers had with the UK’s participation in it.
EU policy makers will struggle to strike that fine balance between being soft enough in the Brexit negotiations to establish a healthy new trade regime with the UK, and hard enough to discourage other disgruntled member countries from hauling out the ballot boxes. The myriad interests involved and the sheer complexity of that balancing task suggest headache inducing game theoretic outcomes. Early signs of the disorder to come:
- While the UK apparently expected preliminary negotiations in advance of the parliamentary vote and subsequent issuance of the official letter invoking Article 50 of the Lisbon Treaty regarding withdrawal, the French and German leaders stated unequivocally that there will be no talks prior to receipt of the letter
- UK Prime Minister Cameron has chosen to resign and is expected to step down by October. It will fall to his successor to shepherd the parliamentary decision on the Letter, and new elections, if announced, could usher into power a pro-EU political party or coalition
- Which brings up another issue – the general elections in several other leading EU countries in 2017 (The Netherlands, France, Germany). Do changes in leadership upset the EU’s ability to reach consensus on how to deal with Brexit?
- Some have suggested that the UK might gain access to the Single Market, yet maintain sovereign control over immigration, but the foot-stomping has begun on the other side for the guiding principles: “all four, including immigration”
3. The Independent Fed Controls US Interest Rates, Except Right Now
Market observers have debated “will they or won’t they” all year as economic data releases swing the weathervane atop the barn this way and that. Quaint conjecture at this point, especially when contrasted with our own concerns at points in 2015 that the Fed may raise “too much, too fast.” In the wake of the UK referendum results, we expect dovishness in Europe, the UK and the US. The LISI Investment Committee is split on whether a December Fed rate hike is forthcoming, as the FOMC must consider boosting its feeble armory of just 50 basis points to cut in the event that the long, shallow US recovery (now the fourth longest in post-war history) does come to an end and contraction ensues.
Given the mixed signals offered by US economic statistics, we thought we would trace the Fed’s qualitative take on what they see, in the chart below (our view is reflected by the shading: dark is negative, light is neutral and no shading positive for the economy in real terms).
We believe that central banks in most developed economies will continue to maintain low rates and engage or re-engage Quantitative Easing via asset purchases. We track Manufacturing PMIs as a barometer of coming GDP growth, and see continued weakness in the Eurozone, mixed signals in the US (though the latter two remain above 50, which is positive; see chart below), and China turning over after some early-year strength. We think that, particularly in the Eurozone, PMIs will begin to suffer due to the uncertainty surrounding Brexit terms and the consequent effects of reduced demand among the UK’s major trading partners. Note it is not just trade, but domestic business investment decisions, hiring, etc. that will likely find stifling to some extent. Upcoming elections in major European countries add to the uncertainty.
4. Market Effects and Portfolio Strategy
The LISI Investment Committee expects market performance in the wake of the UK referendum to remain muted. We see low returns in sovereigns and investment grade fixed income, and better yields in high yield that carry the added risk of whipsawing pressures from developments in the Brexit process. These pressures will become clear as the follow-on effects of the UK withdrawal negotiations take shape, through business investment metrics, consumer confidence surveys and measures of banking sector health. Already there is talk of government intervention to buttress banks in EU periphery countries, notably Italy. For equities, augmented policy accommodation measures across different markets may serve to lift asset valuations, but both equities and high yield are subject to potential downdrafts and volatility as the market encounters Brexit-related perturbations.
Briefly, across asset classes the LISI Investment Committee favors the following:
- Fixed Income – Choose quality over duration and extend maturities. Take advantage of recent yield tightening in riskier parts of the asset class to reduce exposure there (see Risk Premium chart below). Allocate to higher grade credits for safety, and extend on the curve to obtain higher yields. We see low rates for the foreseeable future, and judge there to be good risk-reward in this strategy.
Further, we think yields in the US compare well on a relative value basis, once the risks inherent in European credit are taken into account. For this late cycle time in the US, consider beginning to rotate out of early cyclicals like telecoms and discretionary consumer, and into solid industrials, utilities, selected health care/pharma and opportunistic high-grade energy credits.
- Equities – We maintain our positive view on equities, but think that very low interest rates can artificially boost equity valuations and may support potential bubbles, or at a minimum reduce the rigor with which investors analyze companies before taking positions. This may pose danger for equity allocations as the real effects on companies in the wake of Brexit pressure returns. We believe it is best to stick to bellwether large caps in stable and growing economies like the US, even as European volatility may offer attractive entry points for large, stable companies.
- Alternatives – Alternative assets such as REITs, CTAs, and Long/Short equity funds, allocated in portfolios where appropriate diversification can be achieved (due to risk tolerance needs and minimum position sizes), can provide non-correlated ballast to help dampen potential volatility going forward in these uncertain times.
Finally, we would like to highlight an issue of potential relevance for some domestic clients with retirement accounts. In April, 2016, the U.S. Department of Labor (DOL) released its final regulation defining “fiduciary,” which expands the circumstances under which brokers become fiduciaries under ERISA or the Internal Revenue Code. Generally, the effect of this new rule, to go into effect in April 2017, will be to restrict a broker-dealer’s ability to offer advice unless a customer is in a fee-based account. As the costs of establishing the infrastructure to comply with fiduciary rules are high, we expect many financial institutions to guide retirement accounts toward fee-based structures. We will continue to monitor developments on this issue. Your investment professional will contact you if you have an affected account with us.
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