In the interests of timeliness and recognizing the upcoming holiday weekend, we are providing an abridged Market Update to address the immediate market movements.
June 24th almost looked like it would be the day of reckoning that the market bears have been waiting for. Markets had been relatively calm for the entire quarter, with domestic equity prices creeping slowly toward all-time highs. Combined with minimal volatility, there was a steady information flow with few surprises. That all came to an abrupt halt last week when the U.K. voted to leave the E.U. While polls started to show Leave gaining favor in the preceding week, the vote still took the markets by surprise. Despite polling, money managers, infamously accurate betting houses and Leave voters themselves all expected undecided voters to veer towards the status quo and avoid the catastrophic ramifications of an exit from the E.U.
If you dig into the voting patterns, you see a story that is deeply troubling for the U.K. Scotland voted overwhelmingly to stay, as did Northern Ireland by a smaller margin. Both regions are now weighing their options to leave the U.K. Within England and Wales, voting diverged across age demographics. Over 80% of those over 55 voted and most did so in favor of leaving. Meanwhile, 64% of the 18-24 age group did NOT vote, despite having the most to lose from an exit.
Since the vote, the leadership has been thrust into chaos as Prime Minister David Cameron announced his resignation and the Leave campaign unable to assemble to carry out the transition they initiated. Combine the deep divisions across British society with a rudderless political structure and you have a recipe for a decade of economic stagnation and social upheaval. Meanwhile, the E.U. still faces income inequality, immigration, and an aging population. If it were ever a time to look elsewhere for a engine of global economic growth, now is that time.
Figures for the U.S. are encouraging – employment figures continue to improve ever so slightly, there is nominal GDP growth and housing prices progress upward. However, we still have not seen a clear path to further economic expansion that would counterbalance the issues in Europe. The movement up in U.S. equities reflect sentiment that the U.S. will continue to decouple from global issues, a belief that we do not hold. U.S. companies are closely intertwined with international markets and will never be fully insulated from volatility in China or political changes in Europe.
This can be seen in the bond market, which has had a remarkable year. Annualized returns in the various bond sectors are all in the double digits (or roughly 5-9% gains for year-to-date). Some of these gains are misleading, as the energy fixed income sector is simply recovering from a beating late last year. Still, the U.S. dollar is the safe haven currency and U.S. debt is the “safe” risk asset for now. The Fed has supported this notion by keeping rates low. With just one rate hike this year, and no more expected for 2016, we will continue to have a regimen of cheap money.
None of this should be viewed without looking into the social and political dysfunctions we face here in the U.S. The factors around the Brexit vote have stunning similarities to those of the U.S. presidential race. You have a deeply divided conservative party, an immigration debate exuding racial hatred, and a discourse full of factual liberties and lies. In a possible foreshadowing, since the morning after the vote, Leave campaigners have retracted promises, seen European leaders publicly reject their characterization of post-Brexit relations, and scrambled over who will become the next prime minister. And in the meantime, the pound fell to a 31-year low and has not recovered.
While there are many commonalities across trade, subsidies and immigration, the core issue here is vast income inequality that is either ignored or institutionalized. Until there is a solid dialog and commitment from politicians to meaningfully address this problem, it will only get worse in the coming years. We have seen many insightful and thoughtful analyses of this issue, and will start to share some of these on the Vodia blog.
While we did not foresee the Brexit result, we have been defensive in our portfolio construction for the year. It is grounded in a fundamental view that drivers of growth are limited while drivers of volatility are abundant. Equities are about two-thirds of their long-term target levels, or lower in some instances, with a continued mix of healthcare, industrials, technology and pure dividend stocks. The corollary is that we have a heavier balance towards fixed income – both corporate ladders and actively traded structured notes – which continue to beat their respective benchmarks and provide stable portfolio growth. We are also holding a high cash and cash equivalents position – 15% on average. This enables us to buy on excessive market volatility.
This mix has worked well for the year, but we recognize that there will be continued volatility in the markets until there is more clarity on the U.S. election and global economic conditions. Below are the charts that are most relevant to this discussion, while the Live Market Update will provide clients with a deeper analysis of the markets.
All the best for an enjoyable and stress-free summer.