So that’s it. BREXIT.
It’s real, it’s alive and it just arrived at a share portfolio near you. Or even in your house. It was certainly a surprise, and surprises are the thing that markets do not like!
Let’s start our examination of the situation with some perspective.
The Asian region was the market that was open as the votes counting started to swing towards the Leave vote. Our market started the first ten minutes by rising 0.6%, but then the as the news started to filter down, the market lost 2.6% by 11 AM. It bottomed out at around 2PM, being down 3.7% and then started to rise, finishing the day down 3.2%. Most other Asian markets fared OK, with Shanghai down only 1.31%, India down 2.2%. It is a key consideration that the emerging markets performed relatively well, which supports our general view that valuations there are much better than many developed markets. By contrast however, Japanese stocks finished the day down 7.26% as the soaring Yen shattered the traders who were on board the crowded short Yen/long Japanese stock trade. The Yen was the safe haven currency of the day soaring 12.95% against the pound and 3.88% up against the USD which was the next strongest currency.
As European markets opened, the Euro Stoxx 50 index crashed on the open, but found its low within the first half hour down 9.9% from the previous day. It then found some buyers, and spent the rest of the day crawling along the floor, finally closing down ‘only’ 8.62%. The country at the epicentre of the political fallout actually fared much better. The UK FTSE 100 index initially fell by 8.6% from the confident close it made the day before, but then found very strong support, and finished the day the least weakened out of all the European markets to be down only 3.15%.
As mentioned, some perspective here is very useful amid all of the angst and panic.
Markets reached maximum Brexit pessimism back on Tuesday the 14th of June. The FTSE 100 then was at 5923 points. In the seven trading days that followed (to Thursday the 23rd), it rallied 415 points, or seven percent!
So all that happened by the close on Friday night in the UK was that it gave up around half of the gains made in the previous seven days. It was still 3.6% HIGHER than it was on Tuesday the 14th of June. More than that, at 6138 points, it is still 10.8% higher than it was back in the doldrums of February.
For every action there is an equal and opposite reaction. Sterling (the UK Pound) was the big loser on the night, down 12.95% on the very strong yen, down 8.05% on the US dollar, and 5.75% lower against the Euro. This currency weakness is what is supporting the stockmarket in London, since a lower currency (within reason) makes your exports more competitive, even if you have just ‘given the bird’ to your biggest export customer. Just look at what Japan is trying to do with their currency. Make it weaker to support the exporters. Everytime the Yen falls a significant amount, the Nikkei rises.
These massive currency moves are making banks and market makers extremely cautious. Reportedly the Commonwealth bank has suspended trading in GBP until Monday for retail customers.
Rather than be concerned about the UK being able to stand on its own, it appears that there may actually be more concern about what happens in the rest of the EU. Spain will hold a general election on Sunday and it is hard to say if the financial fallout will encourage them to give the conservative Popular Party of Mariano Rajoy the majority it failed to secure in December, or embolden them to choose leaders that will also pursue life outside of the EU. Spexit may become the next big trending news item.
What are the likely outcomes?
Interest rates are going to stay lower for longer. Markets had been a somewhat skittish on the ‘threat’ of the Federal Reserve raising interest rates again, possibly as early as July. That would seem to be off the table now, especially since Janet Yellen’s last interview which was quite dovish in the face of volatility. Friday’s volatility will certainly have cemented that position.
Ten year bonds rose in price dramatically last night, as their corresponding yields to maturity fell. The US ten year bond yield fell to 1.52% before finishing at 1.56%. In Germany the ten year bond went back into negative territory (-0.05% p.a.) guaranteeing a nominal loss for anyone who bought last night and holds to maturity.
Central banks have promised and provided huge dollops of liquidity to ensure that brokerage houses can settle trades. Mohamed El-Erian who rose to fame at PIMCO, and now serves as Chief Economic advisor at Allianz says that this is not a Lehmann moment, referring to the near contagion that followed when Lehmann Brothers failed in 2008.
Credit spreads may widen. Credit spreads are not a subject often discussed by retail investors, but it refers to the margin that investors demand to invest in bonds other than those issued by a government. As credit spreads widen – as they do with uncertainty – the price of a corporate bond falls. This may result in a performance drag on corporate bonds (and managed funds that invest in them) as happened in the year to February 2016.
Volatility to remain a feature. The biggest problem with the Brexit is the unknown outcomes. It will have impacts, but we don’t know what they are yet. So as a result, volatility will continue. As we pointed out in the perspectives piece, it doesn’t necessarily mean outright losses, it just means big moves, both up and down. It is important not to get suckered into reacting to either. In a previous blog (you can read it here) posted at what turned out to be the low point in February we warned: “It can be tempting to jump out of your investment position now, with the hope of getting back in later at a lower price, or once the situation is clearer. But that too is fraught with danger, and the theory is much easier than the practice. What if we get a 10% rally over the next two months starting from the day after you sell?” As it happens we did get that rally, up 12% in fact, and those who sold in February would have missed it. We are not saying you need to love volatility, but you do need to understand it and not allow it to control you.
Opportunities will be created. The irony of this is that as prices of fixed interest government securities rise and rates look like continuing to be lower for longer, shares are getting cheaper in price and presenting opportunities for the owner with strong hands. Hard assets that generate income and are difficult to replace are also become more attractive.
The positioning of the Quill Group Investment Committee going into this period, and in fact for more than a year now, has been underweight in equities. We have replaced that weighting that would normally be in shares with other un-correlated sources of return in hedge funds, trading funds and private equity. New money going into balanced portfolios has had net weightings of around 25% to Australian shares and 20% to International shares, with a good part of the latter allocated to conservative managers.
The takeaway for us is this; We have been positioned well. Client portfolios are carrying adequate cash and fixed interest to avoid being forced sellers when the volatility swings to the downside. There may be a point in the future that we want to have some of that cash to increase equity weightings. Right now is not a good time to be a panic seller as long as you have that positioning.
As we alluded to in our headline, it might seem as if you should be doing SOMETHING to protect yourself. Often that SOMETHING turns out to be the wrong thing at the wrong time if it is done as an act of panic. With correct positioning and a portfolio of sensible investments we can advise you, “don’t just do SOMETHING, Stand there”. Hold your ground. Look ahead five years at what the companies you own today will be doing after all this Brexit dust settles.