It has been nearly a week since the historic vote by the British to leave the EU, and after two days of intense selling pressure on stocks globally, as well as a historic drop in the pound’s value, equity markets have rebounded nicely. The FTSE 100 British stock market index has nearly recouped its level prior to the referendum, although with the pound down about 7.5% against the dollar, U.S. investors have not recovered their losses in the index.
Other indicators of market risk are sending mixed messages. Gold remains near its highs for the year after rising 4.5% the day after the vote, and the ten-year U.S. Treasury yield is still bouncing around near its lows of 1.45%, reflecting market concern and a bid for safe-haven securities. Conversely, the Bloomberg dollar index is in the middle of its one-year trading range, and the CBOE volatility index has returned to pre-vote levels, suggesting a normalization of market conditions.
Overall, the equity market appears to be telling investors that everything’s fine, but we are not inclined to agree. For a few weeks now, we have been on guard for signs that the hoped-for recovery in Q2 GDP might not materialize, particularly with respect to employment data. On that front, we are not overly concerned although it will be another week or so before we get June payroll data. However, Q2 is firmly in the rear view mirror as we sit here at the end of June, and what’s done is done.
We are far more concerned about what we believe is the high likelihood of a future pause in spending related to uncertainty about the future of the U.K. and the EU. It is difficult to find any supporting arguments for the opposite case, that Brexit will result in an uptick in spending, or even the view that no change in spending patterns will take place. Given the ‘stall speed’ slow rates of growth that many developed economies have experienced in recent years, an exogenous shock like Brexit meaningfully increases the potential for at least a mild recession, in our view. We believe that conditions have changed enough to warrant a more defensive stance and certainly a shift out of some of the portfolio’s more cyclically-oriented and/or value stocks that are typically more susceptible to an economic downturn.
Second quarter earnings reports will provide an opportunity for management teams to share their views on the impact of Brexit, and we believe they are likely to be guarded and cautious. While the U.K. only accounts for a small portion of U.S. exports, we think the proper framework is global trade rather than U.S.-U.K. trade and believe that Brexit-related uncertainty is likely to cause a noticeable pause in spending. We are also concerned that the constitutional referendum this fall in Italy will further inflame fears about the stability of the EU. And of course, the U.S. presidential election is likely to be another source of market volatility in the coming months.
We think bigger picture offsets to a negative view on stocks could be that the Fed will remain on hold with interest rate hikes for even longer, that there will be some sort of collective central bank stimulus program to try and offset Brexit-related weakness, or perhaps that even though British citizens voted to leave, Brexit will not actually occur. Another alternative could be that the impact of Brexit will be far more benign than some believe. These are all hypothetical scenarios. In contrast, we see increased levels of uncertainty in the near and intermediate term outlook, as well as unknown changes in tax, trade, and regulatory regimes as highly likely and potentially negative.
In our opinion, today’s very low interest rate environment is a sign of weakness, not strength. Low rates are troublesome not only for income-oriented investors who need higher yields but also for the banking system globally, which is threatened by flatter yield curves as well as negative interest rates in certain countries. With rates as low as they are in most developed countries, we think the monetary stimulus guns may be nearly out of ammunition. Fiscal stimulus is probably a more effective approach at this point, but will most likely have to wait for the election in November before any signs of a plan crystallize. For the time being, our assessment of the risks and rewards available to investors in the stock market is materially less favorable than a week ago.
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