It’s tempting to lump the post-Brexit crisis with earlier crises such as the global financial crisis or the dot.com bust. And there’s a certain amount of logic in the lumping. If Brexit is to move behind a merely local market event limited to the United Kingdom and, maybe, the Euro Zone, it will do so because of the monetary overhangs created by global central banks in an attempt to head off earlier economic downturns (The expansion of the money supply by the Greenspan put that fed the dot.com boom and then bust) and then the even more massive expansion of the balance sheets at central banks as they attempted to first stabilize the financial system (a generally successful effort), and then to jump start growth by throwing a wave of cash at economies from the United States of China (a generally unsuccessful effort.)
Against that backdrop it’s tempting to see the danger that Brexit might set off another global credit crisis, like that that followed the bankruptcy of Lehman Bros. and the near bankruptcy of American International Group (AIG) and other financial institutions that required government-led or government-arranged bailouts. And I don’t mean to pooh-pooh those fears. Looking at the holdings of hard to sell illiquid assets at, say Deutsche Bank, I think a shudder or two is in order. According to the New York Times, Deutsche Bank was sitting on 32 billion euros in such illiquid assets at the end of 2015, and that amounts, adding to an analysis by Berenberg, another German bank, to 96% of Deutsche Bank’s core capital cushion. And that’s not the end of problems in the banking system. Banks in Italy and Portugal look to be carrying so much bad debt that they will need so kind of government rescue.
These are huge problems. But the reason is that they won’t result in the kind of global credit crisis that some gurus are predicting is that these are exactly the kinds of problems that the world’s central banks know how to fix by injecting capital into banking sectors, by encouraging the formation of bad banks to hold problem loans, by facilitating recapitalization schemes and the necessary agreement by bank creditors to take less–way less, than 100 cents on the euro. Even in China, which has the world’s worst bad debt problem, the People’s Bank knows the drill for successfully kicking the can down the road.
What worries me the second set of problems because neither central banks nor national governments have figure out how to accelerate economic growth and to boost inflation to healthier levels. All the money that central banks have thrown at the growth problem has resulted in some pretty spectacular asset bubbles. It’s important to remember that negative interest rates, as we have in Germany in particular and the EuroZone in general, and in Japan, generate massive gains in bond prices as existing bonds paying a coupon rate of even a pittance such as 0.5% rise in price so that yields will fall into negative territory. On the equity side, it’s harder to see asset bubbles but I would suggest that a Standard & Poor’s 500 stock index that is trading near all time highs when the U.S. economy is growing at just 1.1% (and where earnings growth for the second quarter is again likely to be negative) has a valuation problem.
Which points me to the way in which any post-Brexit crisis will be different. It will be a slow motion crisis driven by a gradual slowdown in economic growth in the United Kingdom, the European Union, Japan, China and the United States–all those great linked economies of the world–that results in a dimming of prospects for corporate earnings growth. The crisis will be interrupted periodically, as it has been in the last two days, by the hope–against the track record of central banks–that this time they will be able to intervene and get this or that economy growing again. And if will intensify, periodically, as the sloshing of central bank cash from one asset class to another, results in an asset bubble here or there that will collapse with much handwringing and the search for new asset bubbles in the making.
The global economy didn’t look all that ducky before Brexit. And nothing about Brexit provides a boost to economic and earnings growth.
On my paid site–China weakens the yuan, Japan looks to stimulus, why bargain hunting is so hard on this dip, and my take on bank stocks
On my paid site JubakAM.com I aim for a mix of posts on macro trends and on individual stock picks. It’s a strategy I call tactical stock picking.
Over the last few days on this free site and on my paid site, I’ve posted my views on the short-term and medium-term effects of the Brexit vote.
In addition to those posts on my paid site I’ve tried to remember that not everything is about the U.K. and European markets and economy.
For example, today the People’s Bank of China lowered the dollar/yuan reference rate. The last two times the People’s Bank did this–in January and last August–it contributed to an emerging markets sell off. The fears in those markets were that a strong dollar and increasing competition from lower priced Chinese goods would make it tougher for companies from Brazil to India to sell their goods.
Today’s rally, June 28, looks to be based on hope that global central banks will start new stimulus packages. First one up I note in a post today on JubakAM.com, looks to be Japan where the government has proposed new stimulus to weaken a yen that has soared on the flight for safe havens after Brexit.
I’ve also posted, twice, on why the Brexit crisis is so tough on bargain hunters. The first, more general piece, looks at how this is likely to be a very extended crisis–which means that the markets will have time to vacillate between hope and fear a number of times over the next two years. The second, a more specific piece, applies this logic to the banking sector. The tough thing about finding bargain investments among bank stocks is that the sector is undergoing so much change that its hard to know what stocks are selling off because they should and what stocks are bargains because this crisis hasn’t changed favorable fundamentals. I end with a list of stocks to watch as trends in the banking sector develop.
That’s what I’m working on at my subscription JubakAM.com site. (I’m still, yes still, at work on what’s turned out to be a very complicated post on the robotics sector and on one about water stocks that should go up on JubakAM.com in the next day or two. Before those get posted, though, I be putting up a post 0n Brett bargain hunting in the technology sector and the timing of any search for bargains..) I think there’s some value to you in passing on the direction of my thinking about the market on that site. Hope so anyway.
Of course, there’s an ulterior motive to sharing this with you: If you decide that you’d like more of my thoughts on the market in my JubakAM.com posts, I’m hoping that you’ll subscribe to my site at JubakAM.com for $199 a year. (By the way, you can get a full refund during the first seven days if you change your mind for any reason.)
The Brexit vote in favor of ending the United Kingdom’s membership in the European Union effectively took Federal Reserve interest rate increase off the table for July, and September, and November. And maybe even December. Remember that the process of exiting the European Union is a long one–and the two-year deadline for a departure doesn’t even get started until a U.K. government asks for an exit. We could still be in the scary, early, nobody knows what’s happening stages of an exit come December. (This post originally appeared on my subscription site JubakAM.com on Saturday June 25.)
And if a Federal Reserve interest rate increase is off the table for that long and global financial markets remain unsettled for that long and growth in the global and U.S. economy is going to be lower than projected just a month or so ago, I think it’s time to rethink exactly how low yields on the 10-year U.S Treasury can go.
The logic here is pretty simple. In an uncertain financial market investors and traders look for safety in assets such as Japanese government bonds, German bunds, and U.S. Treasuries.
As long as the threat of a Federal Reserve interest rate increase was a real danger, putting cash into Japanese government bonds and German bunds had a certain attractiveness over buying U.S. Treasuries. A hike in U.S. interest rates could send the price of existing Treasuries lower. The end of that threat from the Fed for the months ahead removes that disadvantage.
And that allows the big yield advantage of U.S. Treasuries to come to the fore. The yield on a ten-year U.S. Treasury was 1.56% as Friday, June 24. That compares to a negative 0.17% yield on the 10-year German bund and a negative 0.185% yield on the 10-year Japanese government bond.
If you are looking for safety and would actually like to make a little bit of money while you sit on near-cash, what do you think is more attractive right now? Collecting 1.56% in U.S. Treasuries or paying 0.17% or 0.185% to hold German or Japanese government bonds, respectively.
Which is why bond managers are forecasting a new drop in yields for U.S. Treasuries in the months ahead. Do remember that a drop in yield works out to an increase in the price of Treasuries.
The consensus among these Treasury bulls is that the yield on 10-year Treasuries is likely to drop to something like the 1.38% historic low of July 2012 or even further to a new historic low near 1.25%.
What would a drop to 1.38% or 1.25% from today’s 1.56% yield mean to bond prices–and the gains that bond buyers can think about?
If the yields on 10-year Treasuries fall to 1.38%, the price of a $1,000 Treasury bond would rise to $1130.44 for appreciation of 13.4%.
If the 10-year Treasury yield falls to 1.25%, the gain would be 24.8%.
Mind you I wouldn’t count on Treasury yields falling to match the historic low or to bust through that low to 1.25%. But it won’t take a drop all the way to those levels to make this a profitable position, especially when the U.S. and global economy look weak enough to keep returns from equities to very low levels.
You can, of course, buy Treasuries directly in the market or from the U.S. Treasury itself. And there’s no reason not to–the process is very easy. Or you can make it even simpler for a very modest fee by buying an ETF such as the iShares 7 to 10 year Treasury Bond ETF (IEF.) The expense ratio is a low 0.15%. For the year to date total return on this ETF is 7.06%, which certainly beats the 0.32% return for the Standard & Poor’s 500 stock index. Currently the ETF yields 1.58% and it pays dividends monthly.
I’m going to add this ETF to my Jubak Picks 12-18 month portfolio on Monday, June 27.
It’s useful to think of the medium term effects of the “leave” victory in the Brexit referendum as two connected sets of toppling dominoes.
First, there are the political dominoes inside the European Union (and the United Kingdom) itself.
In the immediate aftermath of the vote, right wing Euro-sceptic parties in the Netherlands, France, Sweden and Denmark have called for their own referendum on leaving the European Union. Special votes aside, beginning this Sunday with the Spanish elections, the calendar of the European Union is marked with a series of regular national votes over the next year that will see the voices of various “leave” parties raised in even higher volumes. It won’t help that the likely results of many of these elections will be a relatively weak status-quo government (in Spain and Italy, for example.) Or that the uncertainties that follow on the “leave” victory in the Brexit vote will slow already slow economic growth in the EuroZone. Or that the policies of economic austerity that dominate the debate in Germany, the de facto leader of the Euro Zone, are deeply unpopular in most countries in the European Union and have clearly demonstrated–to me at least–that they don’t work.
Back in the United Kingdom, we’re looking at political turmoil as Scotland, and Northern Ireland, both of which voted to stay in the European Union (by 62% and 58%, respectively), look to renegotiate their relationship with the government in London. (Assuming that London remains the capital. London too voted heavily in favor of staying in the European Union and there have been calls today for the start of a movement to have London leave the United Kingdom and join the European Union.) At the least I’d expect to see Scots nationalists push for a new vote on independence from London (and membership in the European Union.) Any likely Conservative government that will replace that of recently resigned Prime Minister David Cameron is likely to be headed by a politician that campaigned for “leave” (Can you say former London mayor Boris Johnson?) and be truculently opposed to any negotiating stance that smacks of compromise with the European Union or Scotland, Ireland, Northern Ireland, and Wales. (My nomination for the worst job over the next two years isn’t negotiating the terms of the country’s departure from the European Union, but hammering out some agreement on the treatment of the new border between non-EU Northern Ireland and EU-member Ireland.) The Labour party is likely to be in turmoil as members–thought to be about 60% to 70% pro-EU–blame current leader Jeremy Corbyn for the defeat of the “stay” position in the referendum. Add in the gonzo mess that is the UK Independence Party (UKIP) headed by Nigel Farange, with its ultranationalist rhetoric of keeping immigrants out and its belief that the United Kingdom will be able to negotiate tariff-free access to the European Union after the vote to leave (I’m not making this up. See here http://www.politico.eu/article/post-brexit-ukip-wants-tariff-free-access-to-eu-single-market/ )
Looking around the United Kingdom and the European Union as politicians begin the two-year process of negotiating the country’s departure from the European Union, the overall impression will be chaos, with out of control rhetoric, and nary an adult in sight. (How long can Angela Merkel find the energy to try to play this role? She does have her own domestic anti-immigrant party to worry about.)
Which would be bad enough if there wasn’t a good chance of seeing the United Kingdom and some parts of the European Union slide into recession in the next year. Think the uncertainty over the rules of the economic game won’t lead businesses to cut back on investment? Think tourists won’t decide not to take a trip because they don’t know what the border rules might be? Think English retirees won’t have second thoughts about buying property in the south of France or on the Spanish coast? Think Polish restaurant workers in London won’t decide this is a good time to explore returning to Warsaw?
Moody’s Investors Service lowered its outlook on the United Kingdom’s credit rating to negative from stable on June 24. It cited slower economic growth in the country as a result of the Brexit note and more pressure on the country’s finances as the United Kingdom continues to struggle with a current account deficit that requires large inflows of overseas capital. (Which is likely to require higher interest rates after the Brexit vote.) Fitch Ratings, the last of the big three credit rating companies to give the United Kingdom a AAA credit rating, called the high credit rating “untenable under the circumstances” after the vote.
Economic analysts seem to be divided between the optimists who simply see growth slowing in the United Kingdom after the vote and the pessimists who expect a recession. Deutsche Bank, for example, cut its forecast for 2017 to 0.9% from a prior 2.1% forecast. Pantheon Macroeconomics, in the pessimists camp, sees slowing corporate investment, lower employment, and depressed consumer spending leading to a recession. Hard to argue with that logic. The United Kingdom did $500 billion in trade with the European Union in 2015–the terms of that trade are now up in the air. (Ireland is the European Union member most exposed to any decline in trade with the United Kingdom since 18.6% of Ireland’s trade is with its neighbor.) On June 24 the pound fell 8% against the dollar–which made U.K. consumers 8% poorer when they go to buy, say, an iPhone or anything else priced in dollars.
How many of these dominoes fall will depend on the reaction by other European Union members–a desire to punish the United Kingdom so nobody else tries to leave will make things worse. (At a minimum such a stance will indicate that Brussels doesn’t understand how much the structure and attitudes of the European Union bureaucracy are a big part of the problem.) And on how quickly and how far growth falls in the United Kingdom after the vote and how many economies in the European Union it takes down with it. It’s not like the problems in Greece and other European economies are a thing of the past.
Second, the fall of these U.K./European Union dominoes will affect the tumble of dominoes in the rest of the global economy.
Remember that when it decided not to raise interest rates back on June 15, the U.S. Federal Reserve gave uncertainty over the Brexit vote as a reason to wait. Now that Brexit is a reality as opposed to just an uncertainty, I can’t see the Fed being anxious to increase U.S.interest rates. Higher U.S. interest rates would put more pressure on the pound and the euro. It would slow the U.S. economy at a time when the global economy as a whole looks likely to slow as the force of Brexit hits the economies of the United Kingdom and the European Union. Recognizing this, the futures market has virtually dismissed the possibility of an interest rate increase at the July 27 meeting. In fact, the CBOE calculations show the market now pricing in a 7.2% chance that the Fed will cut interest rates in July and a 12.7% chance that the central bank will cut interest rates at its September 21 meeting. It’s not until the December 14 meeting that the odds include a significant–18.1%–chance of an interest rate increase–and even then the market is still pricing in a 10.2% chance of an interest rate cut.
Much of the Fed’s course will be determined by how the global currency dominoes fall. The pound, of course, is forecast to move lower. The currency, which closed at $1.3679 agains the dollar on June 24, is already down 13.3% in the last ten months. Some currency analysts are forecasting a drop to $1.20. The euro is likely to fall on Brexit uncertainty. On June 24 it moved down to $1.1117 against the dollar. The 52-week low is $1.0524 and I’d be surprised if we don’t revisit that level, especially since the European Central Bank is unlikely to move to strengthen the euro after working so hard to weaken it to accelerate growth. The off-shore yuan–that is the Chinese currency traded in Hong Kong–fell 0.8% against the dollar on June 24.
A stronger dollar carries two risks. First, it will create a drag on U.S. economic growth as it cuts into U.S. exports by making them more expensive in other currencies. Second, it puts pressure on emerging market currencies, which are already feeling the effects of the usual cash outflows in times of uncertainty. Both the Mexican peso and the Brazilian real, for example, fell against the dollar on June 24. This kind of concerted downward move in the yuan and in emerging market currencies conjures up memories of the emerging market sell off of last summer.
The world’s central banks are determined to arrest the fall of as many dominoes as they can. Every bank from the Bank of London to the Federal Reserve issued statements promising to provide liquidity even before the Brexit votes were counted. It’s not clear to me, though, that stretched as they are by near-zero or below-zero interest rates, how much leverage central banks have to affect exchange rates or national economies. The Bank of Japan is in an especially tight spot because the yen’s role as a safe haven currency keeps pushing the yen higher at a time when the Bank of Japan wants to see the yen move lower to encourage economic growth in Japan. The currency appreciated briefly to 100 before weakening at the close to 102.22. A close at 100 is likely to bring intervention by the Bank of Japan–and more currency market turmoil–currency analysts forecast.
Before Brexit the general worry among central bankers was that the world would face another crisis before the global financial system fully recovered its equilibrium from the last crisis. In the wake of the Brexit vote that worry has gained in focus and immediacy.
As the next few days progress, I’ll try to post some concrete moves to take in this period of uncertainty.
By a surprisingly large margin of 52% to 48% the United Kingdom voted to leave the European Union in Thursday’s Brexit referendum.
Global financial markets plunged in a decline all the more dramatic because traders and investors had decided on Wednesday that the United Kingdom would decide to stay in the European Union. On that day, for example, the pound rallied.
As markets opened today on the actual results it was a very different story with the pound sinking to its lowest level since 1985 and the European STOXX 600 index showing its biggest drop since 2008 and the global financial crisis. Around the world money moved away from risk and toward perceived safety. Emerging markets tumbled with the iShares MSCI Emerging Markets ETF (EEM) down 5.38% as of noon on Friday, June 24. The Standard & Poor’s 500 stock index was off 2.8% after an early morning drop in the S&P 500 index futures triggered a trading curb at the Chicago Mercantile Exchange. The U.S. benchmark for crude, West Texas Intermediate, dropped by as much as 6.8% to $46.70 a barrel. Cash looking for safety flowed into the Japanese yen, which climbed 3.5% against the U.S. dollar, and into gold, which climbed 8.1% to $1358 an ounce.
In the short term volatility itself will bring more selling as computerized trend-following strategies designed to limit risk create more selling. When the price trend turns negative–as it has today after four previous days had left the S&P ahead by about 2%–these strategies say sell in order to keep up with index volatility and to limit the size of future losses. Markets saw this pattern at work last August when volatility that started in China led to volatility in U.S. markets that led to selling that finally took the S&P 500 down 11%. The bigger the drop today, June 24, the more selling these strategies will generate next week, Rebecca Cheong, head of Americas equity derivatives strategy at UBS told Bloomberg today. Total sales, she estimates, could reach $150 billion should volatility persist in the S&P 500 next week.
The Standard & Poor’s 500 Volatility Index (VIX) was up 40.46% as of 1:10 p.m. New York time, up from a climb of just 33.51% as of an hour earlier.
If you have volatility trades on the VIX–such as the ones I suggested on April 28 on the ProShares VIX Short-Term Futures ETF (VIXY) up 21.6% today or the ProShares VIX Mid-Term Futures ETF (VIXM) up 7.67% today–I’d suggest leaving them on into next week as this risk-strategy rebalancing plays out. (For that original post on my paid site see http://jubakam.com/2016/04/time-to-trade-volatility-with-the-vix-again/ For a summary of that post see this free site on that date. )
In the slightly longer-term, through, I’d look to exit these trades. Fear and volatility spike in the immediate aftermath of an event like this and then recede–even as the long-term effects just start to play out. I’ll try to sketch in some of those long-term effects in my next post this afternoon.