Market Perspective for July 6th, 2016
Our take on “Brexit” is that it has set in motion a re-examination among European Union nations of the benefits and drawbacks of that union. This process may ultimately resolve itself several different ways. It could result in a tighter union between the remaining nations if they can resolve some currently sticky issues (such as immigration), a weaker union (if concessions are made to remaining countries in order to get them to stay), or it could lead to the break-up of the EU altogether. It ultimately may lead to the end of the Euro currency and the re-emergence of country specific currencies such as francs and marks. On the other hand, leaders in the United Kingdom could effectively nullify the vote by not invoking Article 50[1] of the Lisbon Treaty, making the Brexit referendum a non-event. To put it bluntly, no-one knows how this is all going to play out.
British leaders aren’t sure what they want either as the implementation of Brexit has become a political hot potato. Even the leaders of the Leave campaign have been hesitant to assume leadership and “pull the trigger,” so to speak. At first, EU leaders seemed to stress that they intended to negotiate harshly with the U.K. in order to dissuade any other countries from leaving. After Prime Minister David Cameron resigned and Brexit champion Boris Johnson pulled out of the race to succeed him, it became clear no British leader wanted to rush into Brexit. This led EU leaders to a much more measured response. In any event, it appears the negotiations will not take place until Britain has a new Prime Minister. There are 80,000 pages of EU agreements, according to British newspaper the Guardian. The actual process could take years.
Again, despite all that has been said and written over the past week, I really don’t believe anyone knows what Brexit’s impact will be. Some have suggested that it will be a boon for the English to be free of EU regulation. That may be. On the other hand, trade that was once tariff free will certainly no longer be so. Economically that is huge. Import and export quotas will have to be negotiated, as will the right of British citizens to live and work in EU countries.
Because of this, it seems to me that this uncertainty should cause investors to be cautious and demand a small uncertainty premium from all stocks in general and a larger one from European stocks specifically. For the two days following the referendum, that is exactly what happened. Then on Tuesday June 28th markets began to rally. At the close last Friday (7/1), the S&P 500 stood almost exactly where it had closed on Thursday June 23rd, having rallied close to 2% between June 20th and 23rd on the unfounded notion that the U.K. would vote to remain. Heads the market goes up, tails it goes up apparently. Clearly there is a more powerful force at work than whatever comes of Brexit, because in essence U.S. stocks have completely shrugged it off[2]. See Chart 1. That force is low and falling interest rates.
Chart 1
Brexit spurred a decline in the ten year Treasury note from 1.74% to 1.36%, as investors concluded the ongoing uncertainty almost assures no rate hike in 2016. See Chart 2. Lower long term interest rates implicitly raise the current value of every future dollar earned, thus theoretically justifying higher prices. Every time you think stock prices can’t go any higher unless corporate earnings improve because bond yields certainly can’t go any lower, bond yields somehow do go lower. It doesn’t even seem to matter that earnings are flat. As the July 2nd Barron’s aptly put it, people are buying treasuries for capital appreciation and stocks for yield[3].
Chart 2
Despite the obvious risks in buying securities that have already rallied substantially (referring to income-oriented stocks and treasury bonds), buying into any market decline is just too tempting in a world where too much money is chasing too few opportunities. It appears that the interest rates bears have capitulated. The consensus now seems to be that AAA yields are heading toward zero. It’s been my experience that consensus is rarely correct. I’m not calling a top, but this just makes me nervous.
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[1] Article 50 of the Lisbon Treaty spells out how an EU country might voluntarily leave the Union.
[2] World stocks are 4% below their June 23rd close, but at more or less the same level as June 14th when polls showed that “Remain” had retaken the lead.
[3] Barrons, July 2, 2016. Page 9.