The World After Brexit by Worth Wray, STA Wealth Management
INSIDE THIS EDITION:
Brexit Vote Hammers Global Stocks
For What It’s Worth
Weekly Technical Comment
401k Plan Manager
Features Articles & Interviews
Brexit Vote Hammers Global Stocks
Written By: Luke Patterson
CEO & Chief Investment Officer
It is often said that investors “buy the rumor and sell the news”. This suggests investors often like to buy stocks in anticipation of good news and then sell once the good news becomes fact. But, what happens when Wall Street “buys the rumor” and then the news is not what the public expected? Pandemonium. Welcome to the aftermath of the Brexit vote.
Stocks around the world reacted sharply. In Italy stocks fell over 10% on the news. France and Japan both closed nearly 8% lower. German stock prices stumbled and so did those of the United Kingdom. The U.S. markets felt the global pull as well and the Dow Jones Industrial Average fell over 600 points on Friday with the S&P 500 down 3.5%.
As a reminder, the vote was a non-binding referendum, that the Prime Minister, David Cameron (who just resigned effective October) stated that he would implement however the results turned out. The Brits voted by a 52%-to-48% margin, with a large turnout (72%) to leave the EU.
Next in line is Article 50 being invoked and the exit negotiations which promise to be anything but smooth. This will likely take years. We will now have to wait to see how the future relationship between the UK and Europe manifests itself. Also, a contraction in the UK economy could be a result of this vote.
There will be elections in Spain on June 26th and in France, Germany, and the Netherlands next year. At issue, as with the Brexit vote, is whether and how this wave of anti-establishment and anti-globalization sentiment spreads.
While the EU leadership is pressing the U.K. Parliament to quickly invoke Article 50 and get the ball rolling for negotiations – at that point, it will be next to impossible to turn back – Prime Minister Cameron, who intends to stay on until October, has said repeatedly that there will not be any move before then to pull the trigger. As long as Article 50 is not triggered, the U.K. remains an EU member.
This is not about business insolvency or a financial event in and of itself – it is about shifting politics… but the resulting shock to foreign exchange markets does have the potential to unleash a series of shocks around the world.
We’re effectively on watch for additional disruptions.
While the vote is a negative shock to a global economy which we have already been discussing and writing about the possible impact. We also discussed and wrote about how the fundamentals of the economy has been deteriorating. In last week’s report, we covered “Economic Risks are Rising”, “Fear Gauge is Rising”, “Oil Falls While Gold Surges”, “Treasury Yield Tumbles to Four Year Low”. STA’s Chief Economist and Macro Strategist, Worth Wray wrote a good piece entitled “ Coming Storm: 10 Reasons to Take Cover” in our June 6th report. It would be difficult to see how the messaging to our clients and readers could have been better in retrospect.
The bigger questions are (1) are the economic fundamentals deteriorating to the point that it brings us to recession, and (2) can the weakening US economy handle the impact of foreign financial shocks. That in my view is the ball to keep our eye on, and we will be looking for the early signals.
The market does not like the uncertainty that this Brexit brings, but there has been the proverbial “flight to safety” which includes precious metals, U.S. dollars, and high quality bonds.
We consider ourselves in good position to weather a volatile market at the moment. Our Investment Committee has positioned the portfolio to be more defensive, and the same has been recommended in the 401k Plan Manager:
This year our larger portfolio themes have been to continue buying quality bonds and raise cash.
It is clear in the charts below in the Weekly Technical Commentary that investors were horribly blindsided by the Brexit vote. It should not have caught our readers by surprise.
For What It’s Worth… The World After Brexit
Written By: Worth Wray
Chief Economist & Global Macro Strategist
- UK voters delivered an enormous blow to global stability last week when they chose to leave the European Union. This “Brexit” event represents both a short-term shock to global financial markets and a lingering catalyst that has set the world on a more dangerous path.
- What happens next is anyone’s guess. The selling pressure in global markets may subside in the coming days as the initial panic begins to wear off and demand for safe haven assets begins to fall, but I’m afraid the knock-on effects of the Brexit shock will make it far more difficult for central banks to maintain global stability for any meaningful period of time.
- Fortunately, we saw this sell-off coming along with its various knock-on effects and positioned client portfolios across relatively defensive investments well in advance.
- Looking ahead, we see a series of risks capable of driving the US dollar higher, commodities lower, and ushering in a major bear market. In addition to weakening US economic growth and the ongoing earnings recession I’ve written about in recent reports, risks notably include (1) European capital flight and bank stress, (2) Japanese foreign exchange intervention, and (3) a Chinese currency devaluation.
- It may sound a bit scary, but falling prices are critical to restoring attractive long-term fundamentals and setting the stage for more attractive investment prospects. While we will continue to follow our tactical discipline by attempting to buy into pockets of weakness and selling into pockets of strength, we believe the BIG opportunities lie at the beginning of the next business cycle
Did Brexit Just Break the Global Recovery?
Just as I warned in my June 6 letter (“Storm Warning: 10 Reasons to Take Cover”), UK voters delivered an enormous blow to global stability last week when they chose to leave the European Union.
It wasn’t a landslide by any means; nor is it necessarily binding. But after most investors assumed the tide had turned in favor of a “Remain” vote just days before the referendum, the final decision delivered one of the largest political shocks in modern history.
As you can see in the poll results above and the charts below, the “Brexit” debate has left the United Kingdom sorely divided.
While most of England and Wales favored leaving, dominant majorities in London, Scotland, and Northern Ireland voted to remain in a vote that divided British subjects along geographic, socioeconomic, and generational lines. [If you’re interested in the specifics, feel free to check out my June 24 update video outlining the referendum and its likely implications.]
Despite all the hyperbole you may be hearing on CNBC or reading about in the New York Times, it’s too early to say how this story will play out for the United Kingdom.
Economic forecasts are all over the map and the end result ultimately depends on (1) whether UK politicians actually follow through with formal negotiations to leave the European Union, and (2) what kind of trade relationship the next Prime Minister can negotiate with EU bureaucrats in Brussels.
With some kind of EU free trade agreement (or perhaps a series of closer trade and/or investment relationships with the United States and China), it’s possible the UK can thrive after taking back its newfound independence. But without re-establishing some kind of relationship with the European market, most economists believe the UK is destined to grind into recession and fade from international relevance in the years ahead.
That’s a debate worth having, but it’s not what we’re focused on at STA Wealth Management.
I don’t mean this to come off harshly (especially toward my friends in the UK), but my colleagues and I don’t really care about what Brexit means for the United Kingdom. We care about what Brexit means for the world; and we care about what it means for our clients’ portfolios.
If you recall, that’s what I warned about just a few weeks ago when I called Brexit “a major and underappreciated risk… capable of fueling not just a summer sell-off… but also a global crisis in the event of a bad outcome.”
As markets began to wake up to the very real risk of a “Leave” win last Thursday night, capital began to rush out of both the United Kingdom and continental Europe and into safe havens like gold, the US dollar, and the Japanese yen.
That’s how the Pound Sterling’s record 12% collapse (admittedly after running up 5.41% against the US dollar in the days before the referendum) rippled through the global system during Friday’s trading session and again when Asian markets opened on Monday morning.
In a matter of hours, the shock sent European bank stocks into free fall. It triggered a 7% crash in global oil prices. And it opened the door for the largest two day drop in China’s US dollar exchange rate since August 2015.
While central banks are clearly intervening to restore global stability, world equity markets have already lost more than $3.6 trillion in market cap since the morning of Friday, June 24. It’s the worst two day loss on record for global equity markets – even worse than the two most painful days following the collapse of Lehman Brothers in 2008 or Long Term Capital Management in 1998.
What happens next is anyone’s guess.
The selling pressure in global markets may subside in the coming days or weeks as the initial panic begins to wear off and safe haven demand for the US dollar starts to fall, but I’m afraid the knock-on effects of the Brexit shock will make it far more difficult for central banks to maintain global stability for any meaningful period of time.
Fortunately, we saw this sell-off coming along with its various knock-on effects and positioned client portfolios across relatively defensive investments well in advance. With that, let’s explore what Brexit means for the world… and for your portfolio.
End of the Euro?
Brexit is not just about the United Kingdom. It’s a vote of no confidence in the broader European experiment and a potential catalyst for its unraveling. No state has ever left the European Union, so the prospect of a messy divorce sets the stage for prolonged uncertainty.
Our worry ahead of the referendum was that a consensus to leave could reinvigorate a series of political exit movements across the Eurozone, lead to a potentially euro-wrecking spike in short-term government interest rates, and trigger a series of major European bank failures.
Now, all of those fears appear to be rapidly materializing.
In addition to calls for similar anti-establishment referendums in key member states like France and Italy, and rising short-term sovereign interest rates in fragile peripheral bond markets like Portugal and Spain, European banks are showing all the signs of a brewing panic.
Not only are European bank stocks almost back to their July 2012 lows – when Greece’s near default almost triggered a global financial crisis – they’re trading as if a financial crisis has already begun.
As you can see in the following chart, Friday (June 24) and Monday (June 27) marked the worst two day loss for EU banks in history… again, worse than the collapse of Long Term Capital Management in 1998, worse than the Lehman fall-out in 2008, and even worse than the worst days of the Euro Crisis in 2012.
Some investors may see this as a buying opportunity, but I see a toxic mess made worse by negative interest rates and now compounded by the Brexit shock. These assets may be oversold and due for a short-term bounce, but tread carefully. You don’t want to be caught holding European bank stocks if and when the music stops.
As Billionaire investor George Soros wrote over the weekend, “the catastrophic scenario that many feared has materialized, making the disintegration of the EU practically irreversible.”
While European Central Bank President Mario Draghi has emphatically promised to do “whatever it takes” to preserve the euro – and the broader European project – his dwindling firepower is not enough to address the ongoing refugee crisis, the rising tide of populist politics, or the steady disintegration of continental unity… all of which could lead to exits and cascading bank failures if things go awry.
The euro’s days may be numbered unless – as Soros notes – the Eurozone can somehow push forward with increasingly unpopular reforms toward “a genuine banking union, a limited fiscal union, and much stronger mechanisms of democratic accountability [in a system where nations relinquish what’s left of their sovereignty].”
That means capital may continue to flow out of Europe toward the safety of US assets and the US dollar for the foreseeable future.
Excuse for Japanese FX Intervention?
If you recall, Japan’s compliance in the tacit “Shanghai Accord” with the US, Europe, and China has been one of the key ingredients in containing the US dollar and stabilizing global markets in recent months. But this fragile ceasefire in the global currency war is now at risk as the strengthening yen weighs heavily on Japanese stocks and pushes the struggling export economy back into recession and deflation.
So far, the public threat of US trade sanctions and frequent arguments with US Treasury Secretary Jack Lew over the acceptable threshold for JPY intervention has kept Japanese monetary policy in check; but key Japanese policymakers appear to be running out of patience as the currency approaches the key ¥100 per US dollar threshold.
Source: Bank of America/Merrill Lynch
As you can see in the charts above and below, the Friday after Brexit was the most volatile day on record for major foreign exchange markets and Japan found itself on the wrong end of that global flight to safety.
Within the space of a few hours, the yen surged to ¥107 per dollar all the way toward ¥100 per dollar as Finance Minister Aso and BoJ Governor Kuroda issued a joint statement asserting their intent to intervene.
Something clearly happened that day as the yen weakened back to ¥103 per dollar within a matter of hours – at precisely the same time we saw similar recoveries in the greenback, the pound, the euro, and oil.
After working so hard to contain the dollar and support a global reflation since the dark days of February, it’s no wonder that major central banks collectively intervened last Friday. But what worries me is that Japan is still ramping up its foreign exchange rhetoric and appears to now be prioritizing its domestic needs over global stability.
We’re no longer talking about senior level government officials and their underlings. The conversation has now escalated all the way to President Abe, who told the press on Monday, June 27, that he had ordered Finance Minister Aso to watch the currency market “ever more closely” and authorized him (and/or Governor Kuroda at the Bank of Japan) to take steps if necessary to counter further yen strength.
In other words, the currency wars may be reigniting in the wake of Brexit… which means we may be just one emergency meeting away from another big surge in the US dollar and all that goes with it.
Cover for a Chinese RMB Devaluation?
As I’ve repeatedly warned for the last few months, China’s currency is weakening sharply and I believe it’s been a key contributor to the violent sell-off in global financial assets.
Though few commentators outside of Asia are paying attention to this key exchange rate, it’s one of the more disturbing knock-on effects of the Brexit shock.
Though the illusion of a more market-driven exchange rate gives the impression that the RMB’s sharp depreciation is more a function of US dollar strength than RMB weakness, Beijing is clearly taking advantage of the latest shock to continue devaluing its currency against both the US dollar AND its policy basket of global currencies.
Here’s a chart from Nordea FX Strategist Martin Enlund (one of my favorite economists on Twitter) to that effect.
What’s more, Premier Li Keqiang seems to be laying the groundwork for further depreciation in the coming days, arguing that instability in distant corners of the world can trigger a “butterfly effect” capable of jeopardizing the global recovery and global financial stability.
That’s exactly the imagery I used last August after the initial RMB devaluation (“What Happens When a Dragon Flaps It’s Wings?”) and it’s extremely telling.
In the event of more extreme Brexit aftershocks, there’s a real risk that Beijing may choose to free float its currency rather than spending its FX reserves and tightening Chinese financial conditions in the process. As I’ve written in recent letters, China’s ability to manage outgoing capital has continued to fall throughout the year despite the springtime improvement in global conditions.
If they do decide to let the currency float (or more likely, to sink), Chinese policymakers are now in a position to look like victims rather than aggressors. The impact on global markets will be just as disruptive, but the media narrative appears to be working in their favor.
Catalyst for a Global Liquidity Crisis?
Much to the Fed’s dismay, the post-Brexit shock has pushed the US dollar back toward its March levels with serious implications for both US and global stability.
I won’t harp on it too much today, since I’ve been writing about the US dollar non-stop since March. But suffice it to say that the US dollar has both direct and indirect effects on global liquidity, in addition to its heavy influence on global commodity prices.
In direct terms, the US dollar is the world’s dominant funding currency. In other words, foreigners tend to borrow in dollars when dollars are cheap, and they tend to get squeezed – sometimes to the point of default – when dollars get more expensive.
In indirect terms, the dollar’s influence is even more powerful. Since a stronger US dollar and higher nominal US interest rates tend to trigger capital flight out of vulnerable markets, foreign central banks are often forced to hike their domestic interest rates even in the face of weakening economies to resist sharp collapses in their currencies.
As a result, global liquidity tends to dry up when the dollar rises, which tends to trigger painful corrections in risk assets around the world… including US equities now that a strong move in the dollar could easily push our weakening economy into recession.
Markets Reward Patience
With all that in mind, it’s absolutely critical to understand that – while the greenback may trade lower in the short-term and the Fed’s rate hiking cycle may well be over – Brexit has just set the table for foreign policy moves and/or global risk aversion that could drive the dollar higher, weigh on global commodity prices, and trigger a larger liquidity crisis in the not-so-distant future.
Such events may have been “tail risks” in recent months, but they’re quickly becoming the base case.
To be clear, I do not believe UK voters’ resounding decision to leave the EU is the cause of the instability we’re seeing in global financial markets this week, although the toxic dynamic between British Parliament and EU bureaucrats may continue to stir up more volatility in the coming months.
Brexit represents both a short-term shock and a lingering catalyst that’s sets the world on a more dangerous path for over-risked and over-extended return chasers, but it’s only having such a violent impact because global growth is so weak and our highly-leveraged, US dollar-based system is so vulnerable.
It’s too soon to say whether the volatility we’re seeing in global markets is a short-term blip with longer-term implications, a correction as we saw in August 2015 and January 2016, or the beginning of a cycle-ending bear market where richly valued US equities and other risk assets stand to give back some or all of their Fed-driven gains.
That may sound like a scary prospect, but this is precisely the process that needs to play out for lower prices to restore attractive long-term fundamentals.
No one should think they can precisely time the market’s twists and turns – especially a market long distorted by unprecedented and increasingly aggressive central bank policy – but there comes a time when enough is enough. It’s not worth reaching for a lot more upside when risks are so skewed to the downside.
In fact, the greatest opportunities for wealth-creation at the end of a bubbly market cycle lie in reducing equities in favor of a more defensive portfolio posture that earns less in the short term, but allows us to take advantage of the BIG opportunities when they arise.
For what it’s worth, I’m optimistic that investors who tread carefully over the coming months may find themselves in a position to profit from some of the most exciting opportunities of our lifetimes as central banks get more creative, governments become more proactive, and the global economy finally starts to restructure itself for the 21st century in the next cycle.
The key is staying disciplined, diversified, and patient between now and then.
-Worth Wray, Chief Economist & Global Macro Strategist
Weekly Technical Comment
Written By: Luke Patterson
CEO & Chief Investment Officer
World Markets Are Shocked At Brexit Vote…
Even though the polls showed the British vote very close, a lot of money bet that the Brits would vote to stay in the European Union. That was true of London bookies and global investors. Strong currency and stock action on earlier in the week added to the complacency. That explains why Friday’s reaction to the vote to leave the EU has provoked such a strong negative reaction. The numbers are pretty bad. The chart below shows the British Pound falling nearly 9% to the lowest level in decades.
The FTSE 100 (below) lost 3% after being much lower in the day.
The Dow Jones Europe Index (excluding the UK) fell nearly 8%. (see below)
Fear Gauge Is Rising (Repeated)…
Another sign of nervousness is the recent rise in the Volatility (VIX) Index. In last week’s report, I included a section entitled “Fear Gauge Is Rising”. I am including it again except with an updated chart of the S&P 500 and the (VIX) Volatility Index.
The chart below shows the VIX (red line) rising above 20 this week. The rising VIX is still reflecting global concerns over the short run.
Stock Indexes Break May Lows…
U.S. stock indexes aren’t falling as far as in Europe, but are suffering technical damage of their own. The charts below show the Dow Industrials and the S&P 500 falling below their May lows and 200-day averages.
Another section is last week’s report was entitled “NASDAQ Slips below 200-Day Line…” The index has now fallen to its lowest level in four months. The NASDAQ Composite is also suffering the largest percentage loss of the three. Even bigger losses are being seen in small caps. A big drop in airlines is also weighing heavily on transportation stocks. All of this is occurring on heavier volume.
Another section last week was entitled “Oil Falls While Gold Surges…” The United Stated Oil Fund (USO) plunged 4.84% on Friday.
By contrast, gold prices are soaring. The chart shows the Gold SPDR (GLD) surging to the highest level since early 2015. Gold is rallying in the face of a bouncing dollar for two reasons. Falling bond yields are bullish for gold (which is a non-yielding asset). Gold is also being bought as a hedge against falling global stocks.
Sector Relative Rotation Model
The Sector Relative Rotation Model shows what sectors of the S&P 500 are strengthening and what sectors are weakening relative to the index. In other words, what is driving returns versus detracting from them.
The chart below (updated through June 27, 2016) indicates relative strength (relative to the S&P 500 Index). Energy, Materials, and Small Cap stocks are leading relative to the S&P 500. Technology and Consumer Discretion stocks have lagged. Consumer Staples, Industrials and Utilities indicates weakening, and Financials and Healthcare indicate improvement in the model. Keep in mind while this model is helpful to analyze sector strength in the S&P 500, it is one tool and should be used with a comprehensive investment discipline
Note: There are four quadrants on the chart:
- Leading (Green) – strong relative strength and strong momentum
- Weakening (Yellow) – strong relative strength but weakening momentum
- Lagging (Red) – weak relative strength and weak momentum
- Improving (Blue) – weak relative strength but improving moment
Featured Articles & Interviews
- Friday, June 24th Brexit Video
Worth Wray, Chief Economist and Global Macro Strategist for STA Wealth explains Britain’s vote to exit the European Union. It is a historic decision sure to reshape the nation’s place in the world.
- Friday, June 17th – What is a Fixed Index Annuity?
What are the benefits of a Fixed Indexed Annuity? What exactly is a Fixed Indexed Annuity? How does a Fixed Indexed Annuity accrue interest? These are some Frequently Asked Questions regarding Fixed Indexed Annuities (FIAs).
- Thursday, May 26th – Michael Churchill
Scott Bishop, Director of Financial Planning at STA Wealth Management hosted a special edition of the
STA Money Hour with guest Michael Churchill, CPA. Mike is a CPA and Tax Manager with ABIP CPAs that
has offices in Houston and San Antonio. Mike and Scott discuss 2016 Tax Planning Ideas to help lower
your personal and business taxes
If you have any questions, please feel free to email me at email@example.com.
STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Michael Smith, President
Worth Wray, Chief Economist & Global Macro Strategist
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
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