Brexit Passed!

Yesterday, in a repudiation of the status quo, British citizens voted to leave the European Union.  The vote for independence was due to frustration over EU restrictions on the UK’s sovereignty.  In particular, Britons became increasingly opposed to policies associated with the Union, such as liberal immigration laws, lack of border controls, high regulatory costs, and restrictions on trade outside the Union.  In our June 15 Market Commentary, we discussed the possible implications of yesterday’s Brexit vote.  Today I would like to expound on that discussion, with an emphasis on the near-term implications.  Our overriding message is to put the volatility into perspective.  We’ve come a long way since the depths of the financial crisis, and the US is still the best house in a questionable neighborhood.

Global stocks are falling as a result of the increased uncertainty. 
However, it is important to keep the losses in context.  In the US, the S&P 500 was up 4.5%, including dividends, so far this year prior to today’s trading session.  Since the financial-crisis lows in 2009, the index has appreciated well over 200%.  A drop of 2%-4% today is likely, but it will only put a small nick in those longer-term returns.  As I write, the various stock indices in Europe are down much more, which makes sense given that those countries are more heavily integrated with the British economy.  Perversely, stocks in the UK are holding up significantly better than the other European markets.  This could perhaps be an indication that the EU needs the UK more than the UK needs the EU.  On the bond side, investors are pouring into safe haven bunds (Germany), bonds (US), gilts (UK), and fleeing bonds issued by peripheral European countries.  This all makes complete sense, and the markets seem somewhat orderly given the circumstances.

Banks stocks are experiencing the brunt of the selling pressure.  There are two reasons for this.  The big money center banks such as Goldman Sachs, Bank of America, JP Morgan, and Citigroup, have large capital-markets businesses that have a large presence in London and that do significant business with Europe and its banks.  Some investors are fearful that another European sovereign debt crisis could lead to “counterparty risk” for the US money center banks.  Essentially what this means is that European banks might not be able to make good on their obligations if their assets, much of which consist of European sovereign debt, decline sharply in value.  In a worst case scenario, there could be another financial crisis as the contagion spreads across borders.  Importantly, though, the US banks are in far better shape than the European banks as the process of recapitalization was completed long ago.  In fact, we just received word yesterday that the major US banks are healthy enough to withstand a “severely adverse” economic downturn.  Those arguing vehemently against the onerous new banking regulations, a by-product of the financial crisis, would be wise to remember this moment.

The second reason bank stocks are falling in the US is that interest rates are very unlikely to rise meaningfully as a result of the Brexit.  Bank stocks in the US had been performing better in recent months on the hope that the Fed would start to increase interest rates.  Higher interest rates would lead to higher loan spreads and increases in net interest income.  That scenario has likely been pushed out significantly.

Interest rates are falling in the US and other “safe haven” countries like Germany. As I write, the yield on the 10-year US Treasury bond is down 19 basis points to 1.56%.  The low was reached back in July, 2012 at 1.39%.  Could we see those levels again?  Sure.  At the same time, the yield on the 10-year German bund has sunk into negative territory again.  Anybody out there who has a savings account knows the implications of these low rates.  Through ultra-loose monetary policy over the past several years, the Fed and other central banks have effectively encouraged frivolous borrowing and punished savers.  This is likely to continue and possibly get worse due to the passage of Brexit.  Good for borrowers (who can qualify), bad for savers.

The dollar, as the major reserve currency and a safe haven, is spiking higher.The British pound is getting especially hammered against the dollar – down 10% at one point today to its lowest level since 1985.  The Euro has also dropped against the dollar today on fears that the trouble will spread beyond the UK.  The increase in the dollar will make it harder for US companies to be competitive in the international trade markets.  This is very important because earnings growth at US companies has been weak for a while now.  One source of that weakness had been slower sales outside the US.  This is likely to continue.

Furthermore, net exports (exports minus imports) is one of the four components of GDP.  While the UK accounts for just over 3% of US exports, our exports to the EU, in aggregate, are much higher.  Another spike higher in the dollar will likely hurt exports and therefore become a drag on US economic growth.  As a reminder, our economy has not been growing that robustly in recent quarters (+1.4% in the 4Q15 and +0.8% in the 1Q16).  It won’t take too much to possibly push us into recession.  Finally, a stronger dollar results in the US effectively importing deflation at a time when the Fed is trying to induce higher inflation.  This will keep the Fed from increasing interest rates, at least through the end of 2016 (in my opinion) and possibly much longer.

The UK is likely to suffer a sharp reduction in trade with the remaining EU members.  Foreign investment into the UK by EU nations is likely to decline as well.  It is worth repeating a quote from the Financial Times that we included in last week’s Market Commentary: “In 2014, just over half of Britain’s trade was with the EU, while sales to and from 60 other countries are governed by agreements struck with the bloc.”  We also stated that EU nations contribute about 48% of foreign direct investment (FDI) into the UK, according to the British government. As the UK is forced to write new trade agreements with the EU over the coming years, the interim reduction in trade and investment in the UK will likely lead to job losses and a probable recession in that country, according to most economists.  The economic weakness in the UK could then spread to a very slow-growing EU and perhaps to countries outside the EU.

Earnings for US multinationals will be negatively affected.  We mentioned this above, but it’s worth repeating.  Estimates vary, but sales outside the US make up around 30%-35% of total S&P 500 revenues.  Goldman Sachs’ Ben Snyder wrote in 2015 that about 7% of total S&P 500 sales are to EU countries, which collectively represent America’s largest trading partner.  At a time when corporate margins are falling from lofty levels, lower international sales could exacerbate the effect on earnings.  This will probably have more than a trivial impact on near-term growth for US multinational companies.

Additional countries within the EU may be incentivized to leave the Union as well. In fact, a possible contagion effect is widely viewed as the biggest risk resulting from the Brexit vote.  The Bloomberg Editorial Board wrote this morning, “Anti-EU sentiment is not confined to Britain.  In 10 EU countries recently polled by the Pew Research Center, the union is viewed unfavorably by roughly one in two citizens.  A median of 42% want powers returned to national governments, versus 19% who want more transferred to the EU.”  As I write, yields in some of the peripheral EU countries such as Greece, Spain, and Portugal are spiking higher.  The rationale for the rising yields is that if these countries also decide to leave the EU, investors in their bonds would ultimately get paid back in a (depreciating) currency other than the Euro.  Therefore, holders of these bonds are dumping their positions to protect against that possible scenario.  Unfortunately, the European banks are holding huge quantities of European sovereign debt, which puts the entire European banking system at risk if the sell-off continues.  And while we have no doubt that the ECB will come in and try to support these markets, there could be a limit to their power this time.

The economic fallout from all the above could result in deflationary pressures in Europe and beyond.  This is bad because a deflationary environment makes it much harder to pay back debt, which by all accounts remains very high across Europe and beyond.  So, if markets start to become exceedingly volatile, we would expect new and creative responses by the ECB and other central banks to fight deflation.  We suspect that if the volatility gets bad enough, the ECB could start buying European stocks.  Japan has already resorted to this.

The protectionist, anti-immigration wave may have implications for the US presidential election.  I was speaking to Mike Melley this morning.  Mike is a trader at CLSA.  Mike said there are inextricable parallels between the Brexit vote and our impending presidential elections.  To be sure, Britons voted for restrictions on immigration, protectionist trade policies, more economic freedom, and nationalism – essentially an “us first” political mentality.  This is essentially Trump’s platform.  Mike said, “For all the heat we have been getting globally for Trump, England just voted for him.”

But are there possible offsets to all the above?  We think so.  Over the past several years, stocks experienced their biggest pullbacks when investors thought monetary tightening by the Fed was imminent.  Starting with the “taper tantrum” and followed by many other bouts of volatility, the Fed was ultimately able to stabilize the volatility and reinstitute the “risk-on” trade.  Is this a healthy thing?  No.  We think the Fed’s support of asset prices is very dangerous for the long-term health of the economy and capital markets.  But it’s hard to argue that a policy of “Don’t Fight the Fed” hasn’t worked out for investors since the financial crisis.  And there are many other positive side effects of lower interest rates.  We suspect that if rates continue falling, homeowners will get an opportunity to refinance their mortgages.  Prospective car owners will be see their cost of ownership decline, thereby boosting auto sales.  In addition, the US is a flight-to-safety country.  Choosing the best house in a shady neighborhood means investment dollars will continue to flow into the US.

Now is a time to keep a cool head.  As I write, the S&P 500 is down around 3.1%.  Recall that the index had fallen more than 10%, into correction territory, in February of this year.  Could we get another drop of this magnitude?  Of course.  But we also might not.  Trying to time the markets with any degree of precision is futile.  As has been the case for several years, we remain fully invested but defensive.  Things could get worse before they get better, but this is how opportunities are created.  Hang in there.