Britain’s Way Out
After a chaotic start to the year, it seemed that markets were ready to find a new, calmer pace. For most of the second quarter, equities moved slightly higher, driven by a number of “good enough” factors. Economic data was strong enough for investors, but ultimately not strong enough to make the Federal Reserve raise rates. Oil prices rebounded enough to make energy companies a top performer for the quarter, but not enough to change market dynamics. Corporate earnings were generally lackluster, but by no means weak enough to drive investors away. This middling performance continued until the end of the quarter, when markets were gripped by speculation on the UK’s future in the European Union.
When Prime Minister David Cameron set the date for the UK’s referendum on EU membership back in February, few seemed to pay the announcement any mind. As the vote approached, however, it quickly seemed to become the only thing anyone could talk about. Yet the more policy wonks and market pundits discussed it, the more senseless this so-called “Brexit” seemed, and consensus ultimately pointed towards a victory for the “Remain” camp. However, the world awoke to a very different result the morning after referendum day, learning that the UK had voted to leave the European Union. Markets plunged as investors reacted to this unforeseen outcome, with British assets hit particularly hard. Though the situation has somewhat stabilized since then, plenty of uncertainty remains with regard to the long term implications this decision will have for Britain, the European Union and for the global economy at large.
It will take some time for some of these consequences to come to light, with Britain’s departure from the EU potentially taking years to complete. On the other hand, some of the fallout from the decision has been quite clear. Almost immediately after the referendum, David Cameron announced his resignation as Prime Minister, and it is now clear that the ruling Conservative party will seek to form a new government. Amidst concerns over the future of the UK’s economy, the pound sterling has hit a three-decade low. Perhaps most striking, however, has been the impact the “Brexit” has had upon central bank policy around the world.
Lower For (Even) Longer
After concerns over a slowing global economy impacted markets at the beginning of the year, some worried about the resilience of US growth. Such fears dissipated this quarter as economic data came in, and was, for the most part, quite positive. Unemployment continued to fall, consumer and housing data remained robust, and first quarter GDP estimates were revised upward several times. With all of this in mind, the prospect of a Fed rate hike not only seemed more realistic, but imminent, as some came to believe the Fed could act as early as this summer. However, after disappointing payroll numbers in May, and comments by Fed Chair Yellen in both the run up and aftermath of the UK referendum, expectations for further rate hikes were pushed back significantly.
Naturally, the Federal Reserve was not the only central bank whose policy trajectory was likely impacted by the UK’s decision to leave the European Union. In an address shortly after the referendum, Mark Carney signaled the Bank of England was likely to cut rates in the coming months, and pursue whatever other measures were necessary to stabilize the British economy. In a similar vein, Mario Draghi expressed concerns Britain’s decision may ultimately have on the Eurozone, and has already made clear the ECB will intervene if needed. Japan, though widely expected to extend its easing measures this quarter, surprisingly took no action. However, accelerated appreciation of the yen amidst the post-Brexit market turmoil suggest the Bank of Japan may be forced to act in the not too distant future. Overall, it seems that amongst the major central banks of the world, the “lower for longer” mantra remains decidedly unchanged.
As we have mentioned in the past, we feel the result of the UK referendum is representative of growing protectionist sentiment in the West. Increasingly, voters on both sides of the Atlantic are expressing their frustrations with the shortcomings of globalization and supporting populist causes and leaders on both the left and the right. While we feel these movements will ultimately be somewhat short-lived, we do not discount the potential harm they may cause in the interim. Other countries may hold referendums on continued EU membership, as eurosceptics throughout the Continent find stronger support amidst a stagnant economic environment and a challenging migrant crisis. In the US, rhetoric on both sides of the aisle leading up to the November presidential election seems to paint a picture of a country more polarized than ever before. While gridlock in Washington is nothing new, we are increasingly concerned it is beginning to weigh on the business climate. Overall, we see political risk as an increasingly important consideration going forward.
At the same time, many of the risks we have discussed in the past appear to be showing few signs of dissipating. Though absent from the headlines recently, the economic situation in China remains uncertain. As a whole, emerging markets have done quite well so far this year, but that is likely to change if news coming out of China again begins to sour. Given the lack of a clear engine of global growth, developed markets would likely be affected as well.
Meanwhile, the Eurozone, already dogged by slow growth and fears of “Brexit” contagion, is now encountering renewed fears over the health of its financial sector. While the Italian banking system has been in focus as of late, we have seen indications that solvency concerns may not be limited to Europe’s periphery. There have been questions over whether Deutsche Bank is adequately capitalized, and it appears as though one of Germany’s regional banks, the Bremen Landesbank, may be on the verge of collapse. We find this to be particularly unsettling, especially given that financial assets in the Eurozone’s core historically have been considered to be of the highest quality. With situations like this in mind, we are unsurprised by the increasingly frequent spikes in volatility we have seen in markets in the past year, and have little reason to believe anything will change in the second half of the year.
While the US has been somewhat of an oasis in the midst of a rather unforgiving global economic environment, we feel it necessary to recognize that is subject to change. This economic cycle is by historical standards quite old, and signs of excess continue to worry us. As such, we have revisited our risk exposures yet again this year, giving particular consideration to our allocations across different industries and exposures to different parts of the capital structure. While we certainly are not trying to be alarmists, risk management remains our highest priority.
We hope that you enjoy the rest of your summer and, as always, greatly appreciate your support and trust.
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