“TINA” is Back

By now I’m sure you’ve heard something about how disastrous the British vote to exit the European Union (aka, the Brexit) will be for both the global economy and the capital markets.  Prior to the vote, pundit after pundit told us how fearful we should be of this heretofore unthinkable outcome.  But nearly two weeks after that momentous vote, things in the US aren’t looking so bad.  US stocks have recovered the lion’s share of the 5%+ knee-jerk drop following the vote.  Interest rates have fallen to near-record lows (based on the 10-year Treasury yield).  And the dollar has benefited from its safe-haven, reserve-currency status.  Today I thought I’d try to rationalize the strong rebound in stocks.  I’ll also shed some light on the action in the bond and currency markets.

Stocks

Faced with the backdrop of record-low Treasury bond yields, stock investors appear to be rotating into defensive US blue-chips that offer solid dividend yields.  In general, investors are seeking two things.  First, they want the relative safety and stability of the US dollar and US assets.  US blue-chips fit the bill because their balance sheets are generally quite strong relative to European sovereign debt, for example.  In addition, US stocks are obviously traded in US dollars. Therefore, if and when the dollar continues to appreciate, foreign investors have the potential to benefit from both stock price appreciation and currency appreciation.  As the chart below shows, we have indeed seen a preference for US stocks relative to both other developed-market stocks as well as emerging-market stocks.

7-6 1Source: Bloomberg.  For DM ex US, we used the MSCI EAFE exchange-traded fund (EFA), which seeks to track the investment results of the MSCI EAFE Index composed of large- and mid-capitalization developed market equities, excluding the U.S. and Canada.  For EM, we used the IShares MSCI Emerging Markets exchange-traded fund (EEM), which seeks to track the investment results of the MSCI Emerging Markets Index.

Second, investors want (or more accurately NEED) yield without taking undue risk.  Here we are thinking about retirees, pension funds, and other entities requiring a minimum amount of income from their investments.  In the table below, we show the yields on the S&P 500 and the 10-year Treasury bond over the past 10 years.  You can see that the S&P 500 is now in the uncommon position of yielding significantly more than the 10-year Treasury.  Faced with accepting just 1.38% annually for the next 10 years, many yield-hungry investors are opting to trade out of bonds and into high-yielding stocks.  This is what the pundits mean when they say that the Fed is forcing investors into “risk” assets.  However, it is worthwhile to note that the purchase of a 10-year Treasury bond at today’s rates entails its own risk – interest rate risk.  If and when interest rates increase, the value of longer-term bonds could decrease materially, catching some investors off guard.  It is clear that given the yield disparity, some investors are seeing a better risk-reward profile from high-quality stocks.  We generally agree.

7-6 2Source: Bloomberg.

Let’s be clear that stock prices have not rebounded based on an improvement in the earnings outlook for any particular sector or corporate American as a whole.  In fact, the passing of the Brexit could negatively affect corporate earnings through weaker global economic growth, a higher dollar (lower exports and increased competition from foreign importers), lower commodity prices, and lower interest rates (which negatively affect bank earnings), among other factors. Rather, the rebound in US stocks and the rotation into defensive sectors reflects the fact that the “TINA” trade has resurfaced.  “TINA”, or “there is no alternative (to US stocks)”, does not exactly engender confidence for fundamental investors, especially following a rapid rise in the markets over the past seven years.  But the combination of being the best house in a shady neighborhood and the increased confidence that the Fed won’t be raising interest rates much could still result in gains for stock investors.  It hasn’t paid to fight the Fed for the past seven years, so why would it start to pay now?

Bonds

Following the Brexit vote, investors have sought the defensiveness of “safe-haven” bonds such as German bunds and US Treasuries.  In fact, as I write the yield on the 10-year German bund is currently -0.20% while the yield on the 10-Year Treasury is near a record low at 1.38%.  It is hard to fathom that investors would agree to pay the German government for the honor of lending money to it.  But for our purposes, let’s focus on Treasuries.  There are four major reasons why Treasury yields have continued to decline in the wake of the Brexit vote.

  • The US government is generally perceived as one of the best credit risks in the world, so during turbulent times investors want that security.
  • Investors are flocking to dollar-denominated assets because the value of the dollar is expected to increase as the British pound and Euro, among other currencies, suffer declines.
  • As shown in the chart below, the 10-year Treasury still yields about 1.55% more (alternatively 155 basis points) than the 10-year German bund.  It is perceived that this spread can only widen so much.
  • Although US domestic inflation metrics had been firming a bit prior to the Brexit vote, there is a perception that Brexit-related fallout will have disinflationary implications.
  • The passage of Brexit has led to the perception that Fed rate hikes are off the table for at least the rest of 2016.

7-6 3Source:  Bloomberg.

Dollar

If you were a British investor, and you had the foresight to swap out of your British assets and into US assets prior to the Brexit vote, you would have made a tidy sum over the past couple of weeks.  In fact, all else equal you would have made over 13%.  This is a massive move, and it brings the British pound to 30-year lows against the USD.  The Euro has declined as well but by a much smaller amount.  Given the rapid pace of change in today’s global economy, investors must consider the currency risks assumed through their investments.

7-6 4Source: Bloomberg.

Will the above trends continue?  It’s anyone’s guess.  But some of the unexpected market developments (read: stock prices) since the Brexit vote offer just another piece of evidence as to why investing requires a dispassionate and level-headed approach.  Very often when the overwhelming consensus believes something will happen, the opposite comes true.  This is why we say that nobody can effectively predict short-term market moves with any degree of precision.  So, will today’s stock prices hold as the effects of Brexit become better understood?  I have no idea, and nobody else does either.  Those predicting a dramatic sell-off in stock prices have been roundly and repeatedly humbled since the financial crisis.  We believe our long-term approach to investing, rather than speculating, continues to seem like a superior strategy.