Brexit. What does it all mean?
Last Thursday the British people voted by a margin of 52% to 48% to leave the European Union. This surprised not only many in the political elite but also many in the financial markets. On Friday, most investment markets lurched into turmoil. The US Dollar, Japanese Yen and Gold were up sharply, while the British Pound was down equally sharply, rewriting key exchange rates in a globalised trade world. Bond yields fell significantly, with the 10-Year U.S Treasury yield down from an already low 1.70% p.a. to 1.50% p.a., driven by investors seeking safe havens as equity markets slumped. All major equity markets were weaker, as was the oil price.
Listen to what Hamish Douglass CEO and Lead Portfolio Manager of MFG Asset Management has to say about Brexit below
Although the initial reactions have been sharp and there may be rebounds in some markets in the coming days, there is equally the prospect of further decay in asset prices in equity and other markets as an understanding of the longer term implications of a British exit from the EU emerges in the minds of investors.
Recognising the risks from events such as Brexit and the upcoming US elections, we had already positioned the portfolios with a reduced equity allocation, building up a strategic reserve of cash, ready to be reinvested after any significant falls in equity markets. The longer-term aim is to accumulate equities, which are attractive from a longer-term perspective in a world where low interests rates support their value, but to do so at more favourable prices.
We would not be buyers of more equities just yet. Our reasons are that the impacts of the British withdrawal will take some time to be fully recognised and they are also widespread and complex.
The process of exit under the Treaty of Lisbon will take at least two years and may involve disentanglement of the British and European economies over a period as long as ten years. In addition there is already a countermovement to hold a second referendum to overturn the one just held. This will protract the whole process as well as add to the uncertainty.
The other aspect to bear in mind is that the British economy (the fifth largest in the world) as well as the British financial system, are deeply interconnected with many other economies and financial markets, in a way that is similar to the pivotal position of Lehman during the global financial crisis.
While Britain will not crash as Lehman did, prompting emergency action by central banks, its interconnectedness is very important. Rather than a rapid crash we may see a long running series of impacts, which take some time to work through.
The central banks have already started reacting with the Bank of England pledging a boost to liquidity and a preparedness to cut interest rates from the current three hundred year low level of 0.5% p.a. The US Federal Reserve is likely to retreat further from its resolve of just last December to lift its Federal Funds rate four times this year. There may be no more interest rate rises in the US this year. We now expect the low rate regime to be prolonged well into 2017 and 2018.
The longer-term impacts of the British exit on the U.S. and other economies is likely to be negative but to what extent is not yet clear. Conventional analysis such as that by Deutsche Bank using the Fed’s own primary economic modelling tool, has outlined how different distortions might be expected to affect economic growth, assuming the Fed leaves its benchmark rate unchanged.
o A 10% gain in the trade-weighted value of the dollar for one year would lower U.S. growth by 0.4% over one year, and by 1.5% over three years, due mainly to the adverse effects of a stronger US dollar on exports.
o A 1% increase in yields of BBB-rated corporate bonds would lower GDP by 0.2 % over one year and by 0.6% over three years
o A relatively persistent fall of 20% in the Standard & Poor’s 500 Index would lower US GDP by 0.2% over one year and by 0.8% over three years.
o Conversely, a 1% drop in the yield on the 10-Year U.S. Treasury note would boost GDP by 0.4% over one year.
All of this will serve to make the Fed more cautious, defer interest rate increases and maintain the low interest rate regime for longer. In the longer run this will be supportive of equity prices but there is no need to rush to build equity allocations.
At the end of April economists and final markets were surprised to learn that Australia’s Consumer Price Index had actually fallen 0.3% in the most recent quarter. This kicked the annual rate of inflation down from an already low 1.7% p.a. to 1.3% p.a. This was one of the more significant movements in economic and financial indicators among the major economies in recent months. The other was the fall in Japanese real GDP growth from a low of 0.7% p.a. to an even lower rate of zero, leaving this major economy on the brink of renewed recession.
As we have indicated recently it is important to assess which market regime we are in. There are many possibilities but the three main ones, in our assessment are:
o Disinflation: such as we have had for most of the last 30 years, where inflation and interest rates fall or at least do not rise (this is good for equity prices). We still rate this as the most likely scenario for the next 3 to 5 years with a 50% likelihood.
o Inflation: such as we had in the 1970s and 1980s where inflation and interest rates rise above 4% p.a. (this is not good for fixed interest or equity prices). We rate this as the least likely scenario for the next 3 to 5 years but now with a less than 20% likelihood.
o Deflation: such as we have seen in Japan and in some parts of Europe in recent years and globally in the 1930s. Where inflation and interest rates turn negative and there is a risk of the economy being trapped in a zero or negative growth pattern. Following the Brexit vote we now rate a scenario of mild deflation over the next 3 to 5 years as a greater than 30% likelihood.
Key takeouts and implications for investment portfolios
Portfolios need to be positioned to cater for all of the main possibilities, by maintaining assets in liquid form (particularly in strategic cash), together with a capacity and willingness to make some shifts in equity allocations depending on how various bellwethers indicate the shifting likelihood of each of the scenarios.
The bellwethers that we monitor include:
•The oil price as proxy for world growth prospects, with which equity market sentiment has become increasingly linked. This indicator is now weaker in the wake of the Brexit vote.
• The steepness of the US yield-curve: the difference between the 10-Year U.S Treasury bond yield and the Fed Funds overnight rate. The more positive the difference, the steeper the curve and the better the prospects for economic growth and equity price growth. A negative yield curve is often but not always and indicator of a recession and an equity market decline, usually with a 12 to 18 month lag. The US yield curve currently has a flattish but still positive shape, but has flattened (i.e. closer to negative) in the last few days.
• Geopolitical shocks which can cause short term declines of between 10% and 15% in equity prices, which subsequently turn out to be buying or accumulation opportunities, if the medium to longer term bellwethers have not changed. So far we have not seen the full extent of the potential downturn from Brexit and so we are watching and waiting before re-investing in equities.