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U.K. Facing a Brexit Hangover – and Markets Aren’t Happy

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Be careful what you wish for – You just might get it.

Today the United Kingdom is facing one massive hangover.  After months of discourse over the grand consequences of an exit from the European Union, the Brexit referendum passed by a rather slim majority (52-48), or by roughly 1.3 million votes out of a country of 46 million eligible voters.  With a 70% turnout overall, you have an extremely divided country.  Some regions voted 70-30 in favor of Remain, and vice versa.

The voting pattern was extremely distinct along demographic and geographic lines.  Scotland voted overwhelmingly to Remain, as did London – both areas where bad weather dampened turnout.  Northern Ireland voted to Remain, albeit more tepidly.  Wales and the rest of England were solid Leave.  The Remain camp veered young and wealthy, and the Leave camp older and poor.

This voting pattern reflects the two core trends in the U.K.: wealth inequality and immigration.  Both have created anger and frustration among Leave voters.  It is the same two issues that have fueled Trump’s campaign.  Interestingly, during the last major shift in U.S. politics – Reagan’s rise to the Presidency in the 1980s – the U.K. endured a similar upheaval with the rise of Thatcherism and the New Right.  After all these years, America and England are in lockstep.

An actual Brexit is a disaster. It will provide no economic gains to the UK and likely increase the wealth gap even further.  It might stem unwanted immigration, but the ensuing economic recession will destroy far more jobs than what is reclaimed. In the meantime, the Scottish independence movement is expected to be revisited and the consequences of a weakening European Union, containing our strongest political and economic allies, will be significant.

As for us, the actual impact on the U.S. economy is likely to be nominal.  It will take at least two years for the terms of a Brexit to be determined, and it is to be noted that yesterday’s vote is not binding, but instead a recommendation.  While there will be change, we don’t know what happens next in the political process.

What we do know is that there will be volatility – the bane of markets.  The pound is swinging wildly today (hitting historic lows) and markets are selling off because of fear.  We have seen this before – some event triggers widespread volatility and markets decline – followed by months of swinging markets until rational heads prevail.

We have positioned the portfolios to buffer such moves, and have a large cash position to take advantage of buying opportunities. Our exposure to the U.K. is negligible, but the impact outside of the U.K is yet unknown.  With Europe still recovering from a recession, this will further challenge that region while continuing to place a premium on U.S.-based assets.  In short, change is scary, but there are always opportunities for the long term.

And now we have a lovely start to the summer of 2016.

Cheers,

David

Brexit Explained: 99 Problems but No Solution in Sight

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To our readers,

Until now I have had the pleasure of writing the majority of our blog entries, but am very happy to now present the writings of Juliana Cusack.  Juliana is our analyst on the venture fund and works closely with investment team on economic matters.  While I will continue to write the quarterly Market Updates and some Market Notes, Juliana will now be a regular contributor to this space.

Her first piece on Brexit is below.  It will help to clarify some of the bigger issues was are facing as we head into the summer months.

Thanks,

David

 

On June 23rd, Britain will vote on whether to ‘Remain’ or ‘Leave’ the European Union (EU) in a move that has significant implications on the US’ biggest ally and the broader European community. The sentiment underpinning this vote is strong and frustrated. The vote itself was a concessionary promise made by David Cameron to a swath of reluctant supporters during his last campaign. While it seemed unlikely to materialize, thirteen days to go and the ‘Leave’ camp is leading by a percentage point in the polls, with 12% still undecided.

The ground-swelling of anti-European sentiment is in large part due to the expansion of the EU in geography and scope, as well as the emergent and fragmented terrorist threat. But like the Trump factor here in the US, the impact of globalization and displacement of blue collar jobs has exacerbated these issues and laid the foundation for xenophobic and isolationist attitudes to take hold. A discussion of each of these factors follows below.

Trade 

Trade is arguably the most important aspect of the European ‘project’, with the European Union initially established as a duty-free trade alliance. The EU currently absorbs 44% of British exports, linked to 3.3 million British jobs. The severity of the impact is, of course, debated and subject to post-exit negotiation, but if the UK left, trade would likely be governed by the WTO, where members can impose tariffs on imports that average 9% when no preferential deal is in place. The relative increase would almost certainly hurt both UK exports and consumers.

Moreover, firms located in London are currently granted a ‘passport’ allowing them to operate in other EU countries without undergoing separate regulatory oversight. This has implications particularly for London’s substantial financial services sector, which currently benefits from being able to clear transactions denominated in euros, a function not possible after an exit. While more limited free trade deals have been negotiated, as with Switzerland, Canada, and Norway, they are unlikely to be lenient in negotiations given the signaling towards the already weakening European unity and the competitive position of the UK’s financial sector.

No one, except European capitals eager to fill the void if London were to exit the Common Market, is arguing the trade benefits that come from membership. If anything, ‘Leave’ supporters are most frustrated with the EU’s evolution beyond a trade alliance, but are still confident that loss of trade will be made up for by trade with China, India, and the US.

Immigration

‘Leave’ supporters are certainly fired up about the EU limiting Britain’s ability to control the number of immigrants reaching their shores, a fact blamed for decreasing wages and an overheated real estate market. Part of this is due to the unprecedented enlargement of the EU. When free movement to the UK for citizens of new EU members was first agreed to in 2004, 100,000 migrants were expected in the first decade after enlargement. In the end, it was 1.4 million, roughly half from the original member states and half from the poorer new members of Eastern Europe. Eastern European arrivals are more likely than previous migrants to settle in small towns, presenting challenges for local authorities. And in fact, the loudest voices in the ‘Leave’ camp come from outside of the capital.

Terrorism

The issue of terrorism is delicately intertwined in immigration issues, particularly given the disparate and concealed threat posed by ISIS. Many people believe terrorists can slip in undetected with streams of migrants, only made worse by the imagery provided by the attacks in Paris and Brussels.

Consider the fact that Ibrahim El Bakroui, an organizer of the Brussels attack was put on a watch list in Istanbul after being arrested near the Syrian border, but no information was provided to Belgium authorities after he was sent back. Cooperation between France and Belgium would also have been prudent as attackers, originally planning to target France, easily shifted their plans to Brussels given their freedom of movement. Local police in Molenbeek, Belgium, also failed to pass on key information regarding the hiding place of the last remaining Paris attacker for three months.

Figure 1: A map indicating EU and Schengen membership across Europe highlights the issue of terrorism prevention when information is not shared between countries with open borders. source: ec.europa.eu

Europe faces unique challenges in preventing terrorism given their porous boundaries, bureaucratic complexities, and inclusion of former-Soviet territories. While the UK is not a member of the Schengen Zone, this prevents the tracking of dangerous persons and strengthens terror networks across borders. Each EU member, including those with freedom of movement, has different legal frameworks and rules on the classification of secrets. Europol has been at the heart of intelligence-sharing initiatives, but the authority has no ability to make arrests and has been slow to garner buy-in from its members.

Political 

The issues around trade, immigration and terrorism are all significant. But some also say that moreover, this is a struggle over identity. The UK is separated from the rest of Europe by language, geography, and culture. As the NYTimes put it, “In [the pro-Brexit] view, the country is being overrun by foreigners who not only take their jobs and welfare benefits, but also bring fundamentally different values into Britain.”

The European Union offers the UK a platform to spread its values and participate among its allies in the fight for human rights and safety in difficult times. This participation offers significant benefits.  But the cost of that is a loss of sovereignty to European officials, unelected by the UK populace but whose laws make up 15% of the UK’s total. People also focus on the UK’s contribution to the EU budget, which totaled 13 billion GBP in 2015.

article-2180177-143FE071000005DC-507_634x426Image 2: An image from the Opening Ceremony of the London Olympics in 2012 celebrated an eccentric image of British culture throughout the decades. 

Your Portfolio

Since polls showed a tip towards the ‘Leave’ camp earlier this week, the FTSE 100 Index (UKX) fell -3.49%, the Euro Stoxx Pr Index (SX5E) fell -4.58% and the S&P 500 fell -1.12%. Global fund managers’ allocation to UK equities are at the lowest levels since 2008 and the pound fell against all 16 major peers. Nevertheless, many say markets are still not prepared for a ‘Leave’ vote, and there would certainly be further fallout for global markets, and the UK and Europe in particular.

There is not much European exposure in the portfolios though there is a small amount of the Vanguard FTSE Europe ETF (VGK), which was added in July 2015. The ETF had a low in February but has been crawling back since. We have also had a rocky time with Santander (SAN), which has been subject to the European instability as well as internal challenges brought on by new leadership. Nevertheless, volatility is dangerous and market events are all felt across borders, including here in the US.

Market Volatility

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We are postponing the publication of our Market Update by a day to address the recent market volatility this week.

The market opened this morning with a bad hangover, dropping three hundred points on the Dow before the official open.  By midday that market was down over 3%, on top of a miserable start to the year in which we are already in correction territory (down 10% from the recent highs).  Put this on the heels of a rocky and lifeless 2015, and people are understandably worried.

This current market has fallen below the levels we saw in August and September of last year, when fears of an actual collapse were circulating.  Now that we are past those levels, the question arises as to whether this slide will continue.  Are we about to experience another 2008 with a halving of the stock market?

While I am the first to admit that this market has us worried – energy prices are dropping without an end in sight and China continues to drag down global markets – I am also optimistic.  The data continues to be very strong in the U.S. and many of the factors driving down this market are grossly overstated.  We are also seeing signs of calm in this volatility with the VIX remaining in the 20s, a relatively benign level showing the mindset of institutional traders.

If this plays out as expected, we are seeing a good buying opportunity for stable companies as we head into a slower growth period in the U.S. and abroad.  We do not expect to see equity returns of the magnitude of the past few years, but there are modest amounts to be made in this environment.

This and plenty more will be covered in our Market Update tomorrow.

David

Bad Year.

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We are just eight trading days into 2016, and it is already one of the worst yearly performances in quite a while – down -7.5%.  The next two days will be critical, however, in determining if this is a trend or another speed bump in an already rocky market.

Using the S&P 500 as a gauge, we are down to levels that are consistent with last August and September, but just above those lows.  We are also at a level on the VIX – the indicator of future volatility – that is in line with September, when the market turned back around during the following four weeks.  It is NOT at the levels that we saw in August when there was real concern that the global markets were on the verge of collapse.

Put simply, this is not a market meltdown in the ways that we saw in 2008.  It is disconcerting, and on the heels of a very volatile and depressed 2015, it may be enough to push investors to be done with equities.  There are two core drivers of this market decline – China and Oil. China may very well be slowing down, but the reaction to these indications has been exacerbated by borrowed money and the interference of the Chinese government in the market. Similarly, oil prices will continue to drive many failures in the energy market, but the fundamentals shaping the low prices cannot continue for much longer.

We see some relief from these levels, but limited long-term upside until the economic picture improves.  The biggest unknown is corporate earnings announcements that will be coming out over the next few weeks.  Volatility will continue  as earnings surprises emerge, but the fundamentals are strong enough to dampen the market volatility in the medium term.

David

Market Note – September 8, 2015

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Last week was another ride through the Volatility Machine. Here’s a look back at the past three weeks, keeping in mind that our daily stock price movements are roughly three times the daily movements of just a month ago.

We can begin the period on August 17, when we saw the first correction in stock prices in over two years. That week, the market was down -5.8%. The following week closed up +1% despite downwards movements of more than -5% through the week. And finally, last week, the market moved down -3.4% leading up to the holiday weekend.

So the volatility continues, and the movements down follow the volatility.  The move up in Week 2 was typical of a “dead cat bounce” when buyers come in seeking quick profits or short traders come to buy back their positions.  Last week, however, saw the continuation of selling with little reprieve.

Meanwhile, reasons for this sell-off are still being postulated.  China is having troubles, but the U.S. and European economies are on stable footing, and we don’t appear to have a systemic collapse of any single sector that would warrant such moves.

One interesting theory has to do with a type of hedge fund that trades based on volatility measures, called ‘Risk Parity’. While the strategy takes many forms, it is designed to move funds out of certain asset classes when the volatility measures start to spike in order to avoid downwards movements. Put simply, stocks start to gyrate, so these hedge funds sell.

This theory would explain the massive selling that we have been seeing, specifically as all stocks are being sold off at the same time regardless of differentiation in solid earnings, high dividends, or both. If it is stock, it is being sold.  However, the theory doesn’t hold much water until we see the data on the hedge funds that will come out in several weeks.

Another variation on that theme is the explosion of risk parity strategies that are being mimicked by the retail asset managers.  While these strategies are far less sophisticated than the hedge funds, the premise is the same – sell before the market dives.  This simple approach of ‘get out the door first’ results in a self-fulfilling prophesy.

Whatever the reason, the trend that we are seeing stays the same.  Volatility has spiked, and with that spike, asset prices are going down.  A bottom will eventually form – and with that, we will see the stock price of good companies move independent of the market – but until that time this is a market that is moving in one big rush for the door.

Regards,
David Matias

 

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Managing Principal

Frozen in Place

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Frozen in Place:

Bloomberg.com had a very interesting insight this morning on the movement of the S&P 500 for this year-to-date.  As of this morning, the market was up around 2% year-to-date, a mediocre performance in a bull market but deeply disappointing for investors after the double-digit gains of the past few years.  But more interesting is the range of movement in the stock level – a total of 6.5% total movement between the high and low for the year.

Going back at least 20 years this volatility of the major gauge hasn’t been this low.  The “deer in the headlights” action of the market is attributed to the mixed economic indicators and the anticipation of Fed action sometime this year.  If rates go up too fast, it could stall the economy, driving down stocks.  If the Fed does nothing, it might indicate that the data is pointing to already weak economic performance.  Something in between is what the market is looking for, but until that happens we are likely to continue in this “in-between.”

It doesn’t mean to show that volatility is low in general.  To the contrary, currencies, commodities and fixed income have all seen significant gyrations this year, with more to come if there isn’t some clear direction soon.

In my opinion, this pause in the market is a very good thing.  It gives corporate earnings a chance to catch up to stock prices, and sets the groundwork for a strong rally in the fall if we see the economic growth is truly able to take hold for the long term.  The indicators that we continue to look at are employment and housing – two key factors to supporting the consumption-based economy here in the US.  Last month’s employment numbers were impressive, starting to take a bite out of the historically low labor participation rate.  But that trend needs to accelerate to really create liftoff in the economy.

More in our Market Update at the end of the month.

News & Noise

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Our 24/7 news cycle produces both news and noise that filter through the markets. It can be difficult for investors to distinguish between the two and stay focused on their primary investment objectives. As a result, investors tend to make emotionally driven investment decisions, which leads to volatility, and volatility drags on portfolio returns.

Back in March the Federal Open Market Committee (FOMC) made quite a bit of noise when it changed its wording. The committee removed the word “patient” from its guidance regarding when monetary policy might be changed. Although the move generated much commentary, it really was nothing more than a symbolic step towards a potential rate increase. There was no change in monetary policy. It was just noise and the S&P 500 dropped -2.75%.

But there are other, and perhaps more consequential, factors at play that have contributed to this year’s volatility. The strong dollar for example, has put pressure on corporate earnings. A strong dollar impacts a company’s international operations and slows growth as their products become more expensive overseas. Falling oil prices and the uncertainty that resulted from the mixed messaging around it has also led to volatility.

Other factors such as economic growth, company-specific factors and industry conditions all play a role in contributing to the overall volatility. Just as falling oil prices drag on the earnings of energy companies, they drag on earnings for the energy sector overall, which in turn hurts earnings of the S&P 500.

All of this gets oversimplified in the headlines leaving people to sort out the news from the noise. In the end, it does not require a great investment of time to distinguish between the two and make good investment decisions as long as there is a disciplined process to ensure the ability to hone in on what is important.