World Economic & Market Outlook
Political Implications
Banking Liquidity
The Conservative party are now looking to elect a new leader, but this will not take place until the autumn. The new Prime Minister is likely to be a Brexiteer with former Mayor of London Boris Johnson the favourite. What the new leader of a Conservative Party actually has a mandate for is much less clear. Those arguing in favour of Brexit encompassed the far right and far left whose sole unity of purpose, leaving the EU, has now occurred, but whose wider political philosophies are much further apart than even the two wings of the Conservative Party. Whether a new Conservative government might seek to get a new mandate from the people remains unclear.
Whilst there has been turmoil and volatility on financial markets, the type of liquidity crisis that occurred on the demise of Lehman’s in 2008 is highly unlikely to occur. Central Banks were prepared for this and Mark Carney, Governor of the Bank of England, has promised to inject substantial liquidity into the banking market if necessary and stated that additional measures will be taken as required. Both the ECB and US Federal Reserve are also standing by to inject extra liquidity as and when necessary.
Political ramifications are likely to spread further than the UK, with anti Europe parties within other Euro Zone members demanding a Referendum or pressing for an exit. Concerns about a potential breakup of the Euro project were reflected Friday in significantly wider bond spreads in peripheral European markets. In America the unexpected election result, which no doubt represented a significant anti-establishment vote, has heightened fears of a Donald Trump victory in the US Presidential election. Within the UK, both Scotland and Northern Ireland, together with London showed a significant majority in favour of Remain. Nicola Sturgeon, First Minister of Scotland, said a second vote on independence was highly likely two years after the last plebiscite.
Market Losers & Winners
BREXIT MARKET UPDATE JUNE 2016
The extent of political concerns about stresses in the Eurozone’s periphery was demonstrated by the significant declines in southern European stock markets. The Spanish market fell by just over 12%, as did Italy and 10 year bond yields in Italy rose by 30bp to 1.53%. In stock markets it was shares in airlines, travel companies and media groups that were hit the hardest, whilst Consumer Staples and Healthcare performed relatively well. Whilst the decline in Sterling is a positive for exporters, FDI flows to the UK are likely to be damaged and in fact Tata Steel has already announced it may not maintain its operations in the UK.
Graham O’ Neill Director, Independent Research Consultancy Ltd
Britain has swept away 50 years of foreign policy by voting by 51.9% to leave the EU. This moment of extraordinary political upheaval has deposed its Prime Minister, sank its currency and unnerved global markets. Designed to unite the Conservative Party, the Referendum only served to divide the country to the extent the United Kingdom itself may not exist in five years time. Markets were wrong footed by events as the most recent polls had seemed to indicate a rise in the Remain camp post the tragic assassination of MP Jo Cox.
Market Moves Sterling saw a record intra-day swing of over 10% between it’s high and low points and the FTSE 100 initially fell nearly 9% before trimming losses to just over 4%. Within the stock market bank stocks and some other financials showed declines of around 20%, as did domestically exposed UK names such as house builders. The more international FTSE 100 Index, where a greater proportion of earnings are generated overseas, fared better than the domestically orientated Mid 250 Index. Banks globally were hit, not just in the UK, with the Euro Stoxx Bank Index falling by around 17%. Across the world banks need higher interest rates to normalise returns on equity and increase profitability from depressed levels, but the prospect of this has moved further away. The US stock market also suffered a significant decline of over 3.5% in local currency terms, both due to uncertainty and the negative impact of a stronger US currency. Havens in times of uncertainty such as gold and the Japanese Yen increased in value. This vote has pitched both the UK and the world into a period of both political and economic uncertainty. This article will look at some of the issues about how long this uncertainty will last and its longer term implications for global markets.
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Some UK commentators and many members of the electorate, held a misguided view that if and when a Brexit vote occurred other European countries would immediately offer favourable terms to the UK to remain within the European Union. In fact the opposite appears to be happening with most European Politicians taking a hard line to the UK Brexit position. This in fact is the most logical approach as it is not in the interest of the Union as a whole in Europe to allow member states to withdraw easily. Thus EU leaders have already confirmed there will be no renegotiation of Britain’s membership terms and are demanding the UK swiftly engage in exit talks and invoke Article 50 of the EU Treaties which sets a two year deadline for withdrawal. This is unlikely to help British interests. One of the ironies of the vote is that the swing factor behind the British exit was working class voters in Labour heartlands, who will now see a more right wing Conservative government, who will surely react to any deterioration in the UK economy and budgetary position with further spending cuts, rather than tax increases. Some voters had expressed a view that their decision to leave had been driven by a desire to preserve the NHS whose prospects now lie with a much more right wing government than has been in place for many years.
Complex Exit Britain’s actual exit from the EU will be complex. The UK has no formula for renegotiating trade agreements and how long this will take is extremely unclear with estimates ranging from 2-10 years. This uncertainty is going to be a negative, both for the economy and global markets. Britain has ended a 43 year membership of a trading block. The political and commercial arrangements sought by the UK but offered by Europe are likely initially to be a long way apart. Matters could be complicated if the new arrangements are not legally in force at the time of exit. Until the UK formally leaves the EU, EU law will continue to apply, but of course businesses and markets look further ahead than the present.
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British companies have enjoyed significant privileges under the single market, not just in goods, but for the UK more importantly in services. Growth in financial services has been a significant and most important driver of the UK economy in the last decade. The longer it takes to tie up new trade arrangements, and especially if these are not in place at the time of the UK’s exit, the greater the risk of a hard economic landing. If no treaty is in place at the time of exit, Britain will be left relying on basic World Trade Organisation terms with no privileged access to European markets for UK companies for both goods and services. Whilst a softer transition could be negotiated this requires unilateral agreement amongst all remaining 27 member states of the EU. Whilst Brexit advocates had spoken in the media about using the Norway model, they did not explain that this would mean living by EU rules such as paying budgetary dues and accepting free movement of workers, with no means to influence them.
Whilst the Bank of England is likely to tolerate a short term jump in inflation, even if it rises to 3% - 4% versus the 2% target, a prolonged or further decline in the currency may not be so tolerable to foreign investors. Bank of England Governor Mark Carney has already commented how the UK relies on the “kindness of strangers” to finance its current account deficit and this kindness should not be taken for granted. A severe loss of confidence in the UK economy given the size of the current account deficit might not be manageable. If the Bank of England were forced to raise interest rates to defend Sterling this would be clearly a further negative. Whilst the electorate ignored the government’s warnings of further austerity if a Leave vote should occur concerns over the UK’s fiscal position on an exit were justified. Ironically those who voted to leave for anti-establishment and anti-austerity reasons, may learn that a loss of economic dynamism which generated tax revenues will impact very directly on them, as the deterioration in the fiscal position post Brexit may prove to be structural rather than merely cyclical.
Economic Growth The UK and Europe are now at the beginning of an extended period of uncertainty which may flow over into the global economy. The new leadership of the Conservative Party, when elected, will now have to turn rhetoric into hard policy and unveil a coherent vision for the UK outside of the European Union. Economic growth in the UK will be adversely affected, in the short-term at least, with implications for the budget deficit which a new right wing government are likely to combat through spending cuts rather than tax rises. Ironically this is going to hurt many of those who voted to exit. The role of the City as Europe’s leading financial centre is already in jeopardy with many investment banks announcing plans to relocate operations to other European countries with accompanying job cuts. It should not be underestimated how London and its globally orientated service sector has driven UK economic growth over the last decade.
For the British economy it is not only services which are likely to be negatively affected. Multinational industrials had been attracted to the UK as a member of the European Union and will now have to reconsider where they wish their productive facilities to be located. At best, until new trade agreements can be put in place, FDI flows to the UK economy will be severely restricted. These decisions drive investment today and post the Financial Crisis corporate capex had already been weak and is liken to weaken further. It is rather ironic that Britain joined the EU as the sick man of Europe, but has since seen far stronger economic growth than occurred before it joined, and growth that has outstripped its European neighbours, in contrast to the position when it entered the EU in 1973. Economic facts show the UK did well inside the EU and many are fearful that it will not do as well outside it.
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Fixed interest markets have also moved to reflect the uncertainty. The 10 year US Treasury yield has fallen by 25bps- a move of more than two percentage points in capital terms. The 10 year German bund yield has traded at a record low of -15bps. (For those asking why anybody of right mind would lend money to Germany at negative rates, it might be worth considering the likely currency moves if Germany moved back to the Deutschmark on a Euro breakup). Markets are now pricing in interest rates that remain lower for longer with a rate cut possible from the Bank of England perhaps to 0% from the current 0.5% over the coming months.
Longer-Term Perspectives For many investors Friday was about short term noise, market reaction and sentiment. For those investing a pension fund, taking a longer term reasoned view on the implications of the Brexit vote is much more important. With our Market Outlooks we have always looked to outline to investors a longer term perspective on both investment markets and the global economy. Investors need to decide whether the Brexit vote has caused a longer term change to the future course of asset markets. There will clearly be a period of uncertainty going forward and how long this lasts will depend on the speed at which the UK can re-shape its trading arrangements with not only Europe, but the rest of the world. Nationalist movements within certain European countries will be strengthened, which could negatively affect confidence within Europe as a whole. This has clearly been an anti-establishment vote.
Currency markets have also seen large moves with the Pound at one stage falling from nearly $1.50 to $1.36. It is the US currency which has been the big winner with the $ index rallying by nearly 3%. The biggest winner on the currency front in this risk off environment has been the Japanese Yen which itself has risen by 3.6% versus the US currency. This has serious implications for the Japanese economic recovery and its stock market. The Euro itself has weakened as concerns about both future economic growth and the whole EU project have risen. The European banking sector has seen declines of 17% and this reflects concerns about the overall strength of the banking system with its wider ramifications for the European economy. In the short term other risk off assets have also suffered with declines in emerging market currencies such as the Mexican Peso which fell by 6%.
Corporate Credit
Fixed Interest Markets Whilst around 90% of economists had forecast the Leave vote would be negative for UK growth, the estimates over the extent of the negativity vary widely. Some economists argue that the uncertainty caused by the Referendum alone had reduced UK GDP growth by 50 bps. Investment decisions are likely to be delayed by businesses and households who may become more cautious and with UK inflation higher, spending power will be eroded. Estimates of the extent of a decline in GDP vary from between 1% - 2% with the UK likely to see at least one quarter of negative growth and even the requisite two to trigger an official definition of recession.
Currencies & Economies
Riskier assets in fixed interest markets have also suffered as corporate credit spreads have risen, especially in peripheral financial bonds where spreads have blown out by 60bps at the senior level and up to 130bps at the subordinated level. Some bank co-cos (higher risk bank bonds that can convert to equities) have seen wider declines. The selloff in the high yield market was at its worst initially with the Crossover Index at one stage 120bps wider, which has now re-traced some of these losses to stand 80bps wider later in the day. Institutional demand for corporate credit is likely to remain strong at the investment grade level, especially in an environment of ECB corporate bond buying due to its QE programme. In fact there were stories of attempts by institutional investors to buy into investment grade cash bonds in size, but were unable to do so as no liquidity was available. The selloff in investment grade corporate bonds provides one investment opportunity as markets are now discounting around a 10x level of defaults than has occurred in recent history. Even with a slowdown in the global economy, this level of stress seems unlikely.
The fall in Sterling of over 11% at its worst in a day is the most dramatic since the currency was allowed to float. In fact the previous record was just over 4% on Black Wednesday in 1992 when the UK left the ERM mechanism. Weakness in Sterling then was a significant negative for the Irish economy. It will only become clear over the next few weeks and months whether such a dramatic decline will have any impact on either banks or corporates. The importance of corporate confidence was demonstrated in the post Lehman period when it appeared that much of the world immediately stopped spending. Brexit will only affect corporate capex negatively, especially in the UK and recruitment by companies is also likely to be put on hold in some cases. If the loss of confidence turns out to be significant, as it was in 2008, this will be very negative for global markets.
Valuations
Investors when looking at markets need to focus on what is priced in and what is not. We have long argued that valuation at the point of entry is the primary driver of longer term returns over, say the next decade. In the April we reminded investors that whilst recessionary fears in the early weeks of the year were overdone, the global economy remained for now trapped in a low growth world where profit growth would be muted. In fact, earnings expectations for 2016 have been further trimmed back to at best extremely low single digit increases in most major markets, whilst some were already expecting a 2016 decline. Sell side analysts were far more optimistic for 2017, predicting a rebound in corporate earnings in double digits, admittedly with much of the expected improvement next year driven by rebounds in Energy and Financials. Whilst improvements in the profitability of energy companies are likely to increase from 2016, a slowdown in the global economy and lower oil price would impact negatively.
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However, one of the larger sectoral adjustments to earnings forecasts is likely to occur in Financials where analysts had expected positive factors such as modestly rising interest rates and bond yields and a steepening yield curve to benefit not only banks, but also insurance companies. These forecasts are now likely to be cut. At the regional level the US and especially Japan will see a negative impact from a stronger currency on profit forecasts. If the US currency were to strengthen substantially, something the US Federal Reserve is likely to guard against, this would be a significant negative for both Asia and the wider emerging markets. Markets entered the Brexit vote towards the highs of recent trading ranges and at a time when many equity market valuations in absolute terms looked expensive relative to 10 year history. The declines that have occurred so far do not take markets back into cheap territory. We remain in a world where both real and perhaps even more importantly nominal GDP growth have converged at low levels. This environment has clearly made it difficult for businesses, especially cyclical ones, to deliver strong profits growth as pricing power has diminished. In a world where nominal GDP is 5%, cyclicals have the ability to raise prices each year, something that does not occur when nominal GDP is in the 1% - 2% range. Investors had hoped that 2016 would see a continued catch-up for the European and Japanese stock markets which had significantly lagged the US in the post 2009 recovery period. For Japan these hopes have been shattered by the strength of the Yen, whilst political and economic uncertainty for Europe means hopes for a proper recovery cycle will have to be pushed out further.
Summary
reversion to mean is unlikely. A world of low growth is likely to become a world of slightly lower growth, favouring bond proxies and economically insensitive stocks which feature heavily in many of the lower risk equity funds which have been recommended to investors over the last 12 months. Today’s environment favours sectors such as Consumer Staples and Healthcare and asset classes such as infrastructure the latter having a heavy weight to businesses with guaranteed, in fact regulated, inflation plus pricing power. The world today is undoubtedly a tougher one for banks, financials, UK property stocks and UK focused domestic businesses. While the prospects for equity returns remain muted over the next few years other obviously attractively valued asset classes remain difficult to find. The spike down in government bond yields, whilst reflecting a lower for longer rates environment, also represents a strong risk off mood in the markets. Unless Brexit impacts so negatively on corporate confidence that a recession occurs, it is hard to find fundamental support for government bonds at current levels. The widening of investment grade credit spreads does mean this asset class looks attractive against cash over the next 12 months. Even though the high yield market is more susceptible to economic uncertainty, the thirst for yield will only increase in today’s interest rate environment. As risks have increased, investors should choose managers with proven research skills in the corporate bond market, both in investment grade and especially in the high yield area.
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The world and stock markets are a riskier place post Thursday’s vote at a time when economic risks post the GFC were still elevated. Heightened uncertainty is likely to affect both corporates and individuals negatively, making them more cautious in a world already showing signs of demand deficiency. The exit from unconventional monetary policy has moved further away with all this means for stock markets and banks in particular. Having commented before that Central Bankers and asset managers were living in unprecedented conditions, Thursday’s vote has only reinforced this and extended the likely duration of these circumstances. Martin Wolf, Chief Economics commentator at the Financial Times, stated this event was the biggest disaster to befall the UK since WWII. Let us hope he is wrong. Certain asset classes like listed infrastructure and economically insensitive sectors will benefit further in terms of market rating from an extended period of low interest rates, so whilst the challenges faced by the global economy and asset classes have increased, there will still be opportunities for strong fund manager skills to exploit. This continues to argue in favour of active over passive management as is demonstrated by the strong outperformance of funds with a bias towards defensive names and away from banks in 2016. Longer term investors still face the challenge of trying to generate reasonable returns ahead of cash to meet retirement or saving objectives. As a result selective exposure to equities should still be taken. It could be argued that recent events only reinforces the attractiveness of lower risk equity funds where the managers focus on delivering a positive return and ignore benchmark indices. These continue to have the prospect of delivering reasonable returns ahead of cash (which may now be a cumulative zero) over rolling five year periods.
Even after the setback which occurred on Friday 24th June, valuation levels mean investors are faced with the same dilemma that has been in place for much of the last 18 months. Markets have front run the recovery and are still not cheaply valued, with the US in particular trading at levels that are expensive when looking at historic valuations or trend earnings. A worry for the US is that with corporates seeing profitability under pressure across many sectors they may respond to this by looking to cut costs through laying off workers. The next recession in the US as and when it does occur is likely to be triggered by this event, although even with the shock of Brexit it would be rash for investors to assume with any level of certainty this will occur over the next 12 months.
High valuations in markets are occurring at a time when corporate earnings growth is muted, which demonstrates how important a low interest rate world has become to market valuations. With rates likely to stay lower for longer some parts of the stock market will be favoured over others. Whilst many investors have commented about the divergence in valuation levels between growth and value stocks, Friday’s events suggest an early
This does not mean that investors should ditch portfolio diversification, but it should be stressed that in today’s world it is ever more difficult to find uncorrelated assets that can deliver the prospect of positive returns in most scenarios. Today’s world of deleveraging and slower growth is now likely to last longer than expected and has already been a multi-year phenomenon.
At periods of market uncertainty with likely low returns from conventional assets it is easy for investors to look to absolute returns funds to deliver the panacea they require. Data from the IA UK Targeted Absolute Return sector shows how difficult this is to achieve in practice in a zero rate world. Many multi asset funds have some exposure to equity markets and corporate credit so may have suffered in Friday’s sell down, with performance depending on the success of their risk reducing basket of positions. These funds do best when the risk premia (expected return over the risk free rate) on conventional assets are high, which is not the case today. Thus these funds have become more dependent on manager skill in selecting opportunistic and diversifying strategies where there is no natural return, and explains why the outcomes delivered by these funds have been below their long term targets over the past 12 months. Whilst these portfolios continue to have the potential to deliver cash +5% returns pre-fees over a cycle, over the next year collectively they may struggle to do so.
Clearly manager skill and understanding corporate balance sheets and growth prospects is more crucial than ever. We commented before that investors will have to live with higher levels of volatility than in the early recovery period and this is not going to alter. We had argued in the April Outlook that after the rally in markets investors should hold some fire power for opportunities presented by a sharp setback. This is now occurring and for conservative investors lower risk equity portfolios not only offer the prospect of a less volatile journey than the overall market, but may also deliver a stronger total return. Whilst the task ahead is not easy, there are a number of managers with proven skills of operating in difficult macro circumstances and it is these funds that should be at the core of investor portfolios today.
Graham O’Neill Independent Consultant
Graham is an investment researcher of international note and has been working in this area for over 20 years. He began his career in the stock broking industry before becoming an institutional fund manager where he practiced both in Ireland and the UK where he worked in senior roles with a number of institutions including Royal Life holdings, Guardian Royal Exchange and Abbey Life. Throughout his career, he has managed multi-million Euro funds and developed innovative investment fund concepts. Seeing the need for non biased, critical analysis of the investment industry, Graham began work as an independent investment researcher in 1992 and since then, principally, he has provided services to financial institutions. Graham is also a director of RSM Group, a leading UK investment research company.
DLS Capital Management 25 Merrion Square Dublin 2
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