A fortnightly look at global financial markets – 4 July 2016
The following is a detailed commentary and analysis from deVere Group’s International Investment Strategist, Tom Elliot regarding: Brexit investment opportunities will follow politics, why does Brexit make investors nervous? Review of capital markets over the first six months of 2016.
Q3 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income relative to benchmark. Longer term outlook is to be pro-risk assets.
Remain diversified in a multi-asset portfolio. There are too many uncertainties facing investors to make significant regional or asset class bets, from continued fear of a hard landing for the Chinese economy, the prospect of a President Trump, and uncertainties over the long-term effects on growth of negative interest rates in Japan and much of Europe. Brexit adds to the global uncertainty.
Brexit investment opportunities will follow politics
- 10 days after the U.K voted to take the U.K out of the E.U, the long term future for the British economy is as clear as mud. Much will depend on what type of trading arrangement a new U.K government makes with the E.U, which takes approximately half of all her exports. Therefore, any investor who is trying to fathom out whether the U.K is a worthwhile investment at present, given the many forecasts of a near term recession and the downgrading of U.K government debt to AA status, needs to begin with politics.
- The adage ‘the revolution devours its children’ applies well to those who campaigned successfully for Brexit. Just 10 days after the surprise decision by British voters to turn their backs on the E. U, the leader of the campaign Boris Johnson has withdrawn his candidacy to become the next Prime Minister thanks to being undermined by fellow Brexit leader Michael Gove, who now also appears unelectable in part because of his perceived treachery.
- Boris Johnson’s departure from the Conservative Party’s leadership race means that there is now no senior Leave campaigner willing to accept an EEA-like deal with the E.U, such as Norway has, since the principle of freedom of movement of labour applies to the EEA. The next Prime Minister will therefore probably negotiate a sub-EEA deal, putting the U.K outside the single market. This applies also to Teresa May, the Home Office minister, who is currently favourite to win the leadership battle. Although she was in the Remain camp, there is widespread belief that she supports the Brexiters’ demand for curbs on E.U immigration.
- The question for investors in U.K companies is: just how much worse will our access to the single market be? If the new government fails to even negotiate a Turkey-like tariff-free deal, and is forced onto WTO tariffs, more pain will come for sterling and mid and small cap companies. Large cap stocks will continue to be protected by positive effect of a weak pound on export earnings, so will be affected less.
- However, all is not yet lost. The U.K may still remain in the E.U, or in the EEA, under some sort of special deal agreed to by E.U leaders anxious not see the U.K leave and so risk further departures from euro sceptic nations. The U.K may have a general election if the new Conservative leader sees that as a good strategy by which to win a personal mandate, if so those members of Parliament who campaign on an explicit policy of refusing to pass Brexit legislation could claim to have a mandate to ignore the result of the referendum.
- In such a scenario, sterling and mid and small-cap U.K stocks will rally sharply, gilt yields will rise and we can expect to see some reversal of the rally in safe haven asserts around the world that we have seen recently.
Why does Brexit make investors nervous?
- Impact on economy. Investors are concerned that capital investment by companies, and spending decisions by households, will be put on hold until a new trade agreement is made with the E.U and we have clarity on the politics and economics of Brexit, and stability in sterling exchange rates. Fear may cause actual harm if the hold on investment and spending causes a rise in unemployment, a fall in general consumption and take us into a recession. The Bank of England has made clear it is willing to ease monetary policy to stabilise the economy if needs be, while Chancellor George Osborne has announced he is abandoning his attempt to have a balanced budget by the end of the decade as he prepares to allow for looser fiscal policy.
- Property.The Brexit vote is seen as another blow to the perhaps over-bought U.K property market. Given the high exposure of U.K banks to this sector of the economy, they have been particular weak and investors have broadened their fears to include European banks in general.
- Politics. The impact of the Brexit vote on U.K politics is more wide-ranging than any had expected, with a real possibility emerging that Scotland may now win an independence referendum and that Norther Ireland may seek to join the Republic Ireland and so remain in the E.U. Any separatism will be feared by other E.U governments, some of whom have restive regions of their own to content with.
- Anti-globalisation.Brexit has given momentum to a wave of popular anti-globalisation and anti-immigration that is sweeping Europe and the U.S. It has been described as a protest against low (and stagnant) wages. Progress on trade deals is less likely in such an environment, with some analysts fearing a President Trump -for instance- may seek to renounce existing agreements. No wonder safe haven assets have rallied, with investors putting money into the dollar and the yen, and the U.K 10-year gilt yield falling below 1% for the first time in its history last week.
- The euro project. With the U.K leaving the E.U, euro-sceptic voices across Europe have been given a boost. There is fear in Brussels that other countries may opt out, and so weaken the organisation. More importantly, this is happening at the same time as supporters of the euro project are trying to coax euro-zone governments to share fiscal and political powers in order to help build a fully functioning single currency. If the euro fails because euro-scepticism prevents this, the impact on the E.U may be fatal.
- Succour to the West’s enemies.Brexit will delight those countries and groups who perceive the west as an enemy, since it weakens the E.U and creates the possibility of conflicting foreign policy goals and hence the ability of China or Russia to play the E.U off against the U.K., or the other way round.
Review of the first six months of 2016
- Stock market returns in the first half of 2016 have been disappointing, but we must be thankful that the bear market of the first six weeks of the year was reversed quickly once the Fed made clear that it would take a measured and ‘data dependent’ view on future interest rate hikes. The Fed has kept to its word, allowing markets to absorb other concerns (such as weak China growth, a looming Eurozone bank crisis and Brexit) without the additional worry that UD dollar credit costs will rise.
- The MSCI World index of developed markets is down 0.5% in USD (down 9% in local terms), while the U.S itself is up 0.9% and the best performing major stock market after Canada and Singapore. For all the alarm caused by the Brexit month, the U.K rose 4.5% over the six months in GBP terms, but fell 4.1% in USD as the pound fell to 30 year lows against the dollar at the end of June. Gold proved to be the best performing asset class, up 26.5%, while other safe haven asset classes such as the yen and government bond markets also performed well with the Barclays Global Aggregate index of investment grade bonds up 9.2% as an increasing proportion of the government bonds in the index fell into negative yields.
- Despite a prevailing environment of low risk tolerance, high yield bonds performed well as investors sought out higher yields, and emerging market equities outperformed developed stock markets (with the MSCI Emerging Market index up 4.8%) thanks in large part to a rally in energy prices and relief amongst over-borrowed companies and sovereigns in much of the developing world that the Fed is taking a more circumspect approach to US dollar rate hike.