Quarterly Market Update
Q&A with Gwynne Shackelford, Chief Investment Strategist of BBVA Compass Global Wealth, and BWS Investment Strategist, Anne-Joëlle Viguier-Galley
In this edition of the BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley review the Brexit vote – its history, the implications, and the outlook for global economies and financial markets.
1. What events led to the Brexit?
It seems that British citizens had increasingly lost confidence in the sustainability of the country’s relationship with the E.U. Many felt that Britain was being held back by the restrictions placed on businesses and the country as a whole by the union, and that the billions of pounds a year in membership fees detracted from the U.K.’s economic output. In the wake of increasing acts of terrorism around the world, Britons also wanted to take back full control of its borders to reduce the number of people coming to live and/or work there. (E.U. membership allows for “free movement of people,” which permits citizens, without benefit of a visa, to go and live in any E.U. country).
On June 23, the U.K. voted to end the almost forty-three-year long relationship with the E.U. Nearly 52% of the U.K. voted to leave, while 48% voted to remain. Turnout was relatively high; an estimated 72% of eligible voters, or 31 million people voted, the highest turnout since the 1992 general election. Both England and Wales voted to leave, while Scotland and Ireland voted to remain.
The U.K. must now invoke an agreement called Article 50 of the Lisbon Treaty, a complex and lengthy process. During negotiations, the U.K. will remain within the E.U., allowing free movement of trade, services, and people to continue. The U.K.’s influence within the E.U. will gradually diminish during that period which is projected to be in the neighborhood of two years.
2. What are the domestic and global implications of the Brexit?
The most obvious and pressing implications of the Brexit are the unknowns given that the U.K. is the first member nation to leave the E.U., the impact on global growth – almost certain to be a negative, the impact on other E.U. countries, and for U.S. investors, the impact on the greenback. We will address each of these implications in turn.
Article 50 of the Lisbon Treaty has only been in force since late 2009 and, because it has yet to be tested, no one really knows how the Brexit process will work. No nation state has ever left the E.U., although Greenland, one of Denmark’s overseas territories, voted to leave, and subsequently did so in 1982. The U.K. will continue to abide by E.U. treaties and laws, but not take part in any decision-making, as it negotiates a withdrawal agreement.
Although the process is likely to play out over a two-year period, the first year will probably be the most telling as folks gain a sense of how harsh the E.U. may be as the parties hammer out an exit package. One side believes global growth will slow because trade will be reduced. The other side believes trade will continue to flourish because the U.K. will be “a free agent” and able to strike better deals with the U.S. or China or any other individual country. But 45% of the U.K.’s exports are to the E.U., indicating the strength of the unification. Indeed, there are so many points and counterpoints to the argument that it is difficult to predict how the Brexit will play out, although there is a universal agreement that it will increase frictions in global trade and slow global growth, in particular global capital formation, which is already weak. Elevated uncertainty raises the return on capital required by companies which tend to invest when profit growth is strong and reduce the pace of investments as profit growth weakens.
Following the Brexit, financial markets initially tumbled but have since rallied, based largely on the assumption that there will be massive amounts of quantitative easing to support any global trouble stemming from the vote. Obviously, the world already has debt issues. With massive quantitative easing programs ramping up once again, and more debt subsequently hitting the market, the global economy continues to move in a vicious circle. The rally also indicates that markets view the Brexit problem as a future one, essentially “kicking the can down the road,” making the situation an even greater unknown.
The U.S. Dollar Dilemma
One of the most troubling questions at home is whether the Brexit will lead to another U.S. dollar rally similar to that of the past two years. Prior to the Brexit, the strong headwind appeared on its way to becoming a tailwind given that the greenback was stabilizing and even weakening a bit, helping to support the revenues of multinational companies.
However, the Brexit could trigger a sequence of events that will stall that advance. Certainly after the vote, the U.S. dollar once again began to strengthen, although it has not fully rebounded to its recent highs. The previous appreciation was based largely on the assumption that the Fed would be raising interest rates, an assumption recently curtailed by a weakening trend in employment growth, six straight quarters of negative earnings growth and international events (from China’s uncertain economy to Brexit). Subsequently, at least for the time-being, the Fed appears to be in a holding pattern as it contemplates the timing of the next rate hike.
Slowing Global Growth
While the U.K. is the epicenter for reduced economic growth in the short/medium term, the impact will spread to Europe, and then ultimately to the U.S. Given that we are already in a very modest growth environment, there is always the risk from any headwind as to what the economy can sustain from a growth standpoint. Every bit of good economic news has been modest in measure. Subsequently, while it takes very little to make investors feel a bit better, it also often takes very little to make them feel worse, given the low degree of real confidence in the data.
U.S. markets, mainly fixed income, remain the recipients of significant capital flows – the country still has the highest sovereign bond yields along with reasonably sound currency and debt. Subsequently, record amounts of foreign dollars are pouring into the safe haven of the U.S. Treasury market. The flows are based to some extent on technical factors, but the flows are also a function of sentiment. While the economy may not be going off a cliff, it is unlikely to grow a great deal either, so a Fed rate hike appears to be benign. People are investing in light of the alternative which is to sit in cash.
Fear of a recession is not the force behind plummeting bond yields; it is rather simply a fear that the economy will continue to plod along, with low inflation expectations. Employment has improved, and although the economy appears to be nearing full employment-- there is still slack in what is termed the U64 employment at 9.9% – the level of growth is insufficient for the Fed to raise rates. As a result, valuations for both equities and fixed income are being pressed to historical highs, although the level of growth is not supportive. Indeed, there is too much growth to justify where U.S. bond yields are, and not enough growth to justify equity valuations, but here we are, pushing both further into extremes.
Impact on other E.U. Countries
Last year financial markets focused on Greece and a potential “Grexit” as the world wrung its hands over the possibly that the E.U.’s weakest economies might leave. In comparison, with the Brexit, the union is losing one of its strongest and largest countries. This places tremendous political pressure on the E.U. to retain its remaining 27 members and to rethink their long term goals.
Italy looks to be the site of the next rotation of crisis. The country is the world’s ninth largest economy and was one of the original countries to enter the union. But, interest rates globally are plummeting, and there is currently around $12.7 trillion in negative yielding bonds, placing tremendous pressure on the banking system. While the unfolding banking crisis in Italy has dominated the headlines, the situation is largely a reflection of the chaos in the underlying economy.
Italy is demographically disadvantaged; with a very low level of university graduates and insufficient capital equipment investments, its productivity has been stagnant since 2000, making it by far the worst performing of the European economies. Poor governance indicators as measured by the World Bank5 do not help Italy’s situation.
Italy plans a referendum in October in an attempt to replace the present legislature with an electoral system that should allow for more stable majority governments.
Overall, Brexit raises the level of global uncertainty. The Party for Freedom in the Netherlands and the National Front in France declared that they will seek a referendum to take Holland and France, respectively, out of the EU, while Scotland and Ireland are expected to also call for referendums. All this underscores the tensions that exist within the EU and the Eurozone.
3. What is the outlook in the wake of the Brexit?
From the standpoint of the U.S. economy, the outlook is less murky than for that of the E.U. Subsequently, as investment professionals, we have become more U.S. centric again, pushing back into U.S.- biased investing. Valuations respective to their historical levels in some of the more defensive sectors including global consumer staples, utility, and telecom companies, are at high levels as investors chase yield and defensive companies. Some exposure to the European and developed international markets is warranted for portfolio diversification, but the outlook for a rebound in international stocks is being pushed further into the future. However, given the long-term nature, implications are widely unknown, and subsequently, we will continue to actively adjust to the dynamic scenarios that are certain to arise.
Leading up to the Brexit, there was much media speculation surrounding the difficulty with the polling process. It was predicted that polling would be difficult, and this proved to be the case. While the consensus was largely that the undecided voter would go status quo and vote to stay, but instead the vote swung the other way.
We may see some of the same inconsistent results with polling predictions in the U.S. presidential cycle because historical standards do not appear to be holding. There are some early indications that people are frequently undecided or unwilling to declare their support. If polling is unpredictable, the U.S. could be open to a shock in much the same way that the Brexit shocked; with the candidate leading in the polls in a tight race, actually losing the election. This is not without precedent, but is unsettling for markets and investors none the less.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).