July 12th, 2016 | By Nick Sargen
During the first half of the year there was a marked decline in government bond yields worldwide to record lows. By mid-year the yield for 10-year U.S. Treasuries had fallen by 82 basis points, while those for comparable U.K. gilts, German bunds, and Japanese Government bonds fell by 104 basis points, 67 basis points, and 52 basis points, respectively. Long-term bond yields throughout much of continental Europe and Japan are now negative.
The plunge in yields occurred in two phases. The first was at the beginning of this year, when worries about the Chinese economy and plummeting oil prices fueled a flight to quality in which risk assets such as equities and high yield bonds sold off. These assets subsequently recovered, as fears about China’s economy proved to be exaggerated while oil prices rebounded close to $50 per barrel after having fallen below $30.
The second wave of yield declines occurred after the British electorate surprised market participants by opting to leave the EU at the June 23 referendum. Initially there was a flight to quality as the British pound sank to a three decade low against the U.S. dollar, while equity markets around the world sold off subsequently. Thereafter, equity markets rallied, as investors anticipated that the Bank of England, ECB and Bank of Japan would ease monetary policies, while the Federal Reserve would refrain from tightening.
Amid these developments investors are now assessing the consequences of Britain’s vote. The most visible impact thus far has been a steep 13% drop in sterling versus the U.S. dollar to a three decade low. However, following a two-day selloff, the FTSE index rallied with other global equity markets following suit. Accordingly, some observers have proclaimed Brexit to be a non-event outside the UK.
Our own assessment is that it is premature to form such a conclusion, as the fallout will be felt for several years to come. In order for Britain to initiate proceedings to leave the EU, it first needs to form a new government at a time when all major political parties are in shambles. According to the Financial Times, The Conservative Party is in the throes of its bloodiest upheaval since the fall of Margaret Thatcher, while Jeremy Corbin of the Labor Party was compelled to sack his shadow cabinet, and Nigel Farage recently stepped down as leader of the U.K. Independent Party. Once the initiative to leave is launched it will take two years to renegotiate new trade, financial, and security arrangements with the EU.
Meanwhile, Britain’s economy, which ranked as the most vibrant in Europe, is bound to feel the adverse impact of increased uncertainty on business investment and consumer spending. The financial community will be particularly hard hit as multinational institutions shift their location from London to other financial centers.
Proponents who favor the decision to leave the EU contend the UK economy will become more vibrant over time, and some believe Britain will be able to negotiate favorable terms with the EU. This seems far-fetched, however, as the EU must be cognizant of the effect that its negotiations with the UK will have on other member countries. In our view, the most likely outcome is the British economy will flirt with recession this year and possibly next, with the magnitude unclear at this time.
The impact is also adverse for the EU, especially on the political front, where Brexit may be a forerunner for events to come in other member countries. In Italy, the populist Five Star Movement has emerged as the country’s leading political party in recent opinion polls, overtaking Matteo Renzi’s ruling Democratic Party. Five Star is led by an Italian comedian, Beppe Grillo, who has called for a referendum on ditching the euro. Some observers have warned that defeat of a referendum on constitutional reform called by PM Renzi could lead to a collapse in the government this fall. Next year, the focus of attention will shift to the French elections, where National Front leader Marine LePen has campaigned on an initiative to leave the EU.
Kenneth Rogoff, professor of economics at Harvard, sums up the European economic and political scene very well when he writes (Financial Times, July 1):
“The biggest economic risk from the Brexit vote is that it turns out to be the start of a vicious cycle of low growth and populist policies that lead to still lower growth and even more populist policies across the west…
If global stock markets want to be blasé about the coming wave of political uncertainty amid a retreat from globalization, that is their business. But policymakers should understand the magnitude of the economic risks. There is certainly no room for complacency.”
For their part central banks understand the risks that are entailed. The Governor of the Bank of England, Mark Carney, has indicated that he favors easing monetary policy to help cushion the blow to the British economy. The ECB is also expected to continue pumping liquidity into financial markets. However, it faces several challenges. One is that there are limits to how negative interest rates can go before investors hoard cash. The other is that financial institutions in Europe are not as well capitalized as those in the U.S., and an environment of low or negative interest rates undermines their profitability. As a result, European bank stocks have come under intense pressure, with the Euro Stoxx banks index testing new lows. The spotlight currently is on the health of the Italian banking system, which has a high portion of non-performing loans, and on Deutsche Bank, whose share price has fallen to an all-time low.
For its part, the Federal Reserve is likely to postpone any action to tighten monetary policy for the foreseeable future. Prior to the Brexit vote, market participants were anticipating one or two moves by the Fed in the second half of this year. However, following the vote, market expectations were that tightening might be delayed until 2018. Even following the stronger-than-expected jobs report for June, the market is not expecting a rate increase until late 2017.
Meanwhile, one event that could have an overriding effect on financial markets is the U.S. presidential election. Most of the time U.S. elections have not had a long-lasting impact on financial markets, because policy changes have been marginal. Therefore, investors have been wise not to overreact to the outcome.
However, there are certain times when elections have had a lasting impact. For example, Margaret Thatcher’s election as British Prime Minister in 1979 is generally credited with the improved performance of Britain’s economy in ensuing decades. Similarly, Ronald Reagan’s election in 1980 (coupled with a transformational change in U.S. monetary policy under Paul Volcker) coincided with the end of high inflation and a weak dollar and the beginning of an era of strong economic growth and lower tax rates, declining inflation and falling interest rates.
The forthcoming election has the potential to be a game-changer should Donald Trump defeat Hillary Clinton, as there is considerable uncertainty about what he would do as President. Trump has campaigned on the theme of making America great again, and his supporters are hopeful he could prove to be another Reagan with a pro-growth agenda. The risk, however, is that his signature agenda – namely, his hostility to global trade, especially with China and Mexico – appears to many to be know-nothing protectionism. It is hard to know whether his protectionist stance is mere rhetoric that is part of a negotiating strategy or is something he would carry out that could undermine the global economy at a time when it is vulnerable to external shocks.
Weighing these uncertainties, we do not believe this is a time where investors should be adding risk to their portfolios. Rather it is a time to review portfolios to make sure they are compatible with risk tolerances. In the case of fixed income portfolios, we are comfortable with maintaining a moderate overweight in corporate credit (both investment grade and high yield), because credit spreads adequately compensate for recession risks. With respect to equities, however, we continue to pursue a more defensive posture on grounds that valuations are not cheap and the quality of earnings and late-cycle dynamics create downside risks that are concerning. Accordingly, we continue to favor companies with low operational and financial leverage, and we continue to increase the overall quality of our portfolios.
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