Brexit winners and losers
Global markets came under heavy pressure on Friday after voters in the United Kingdom surprised the world with a decision to leave the European Union after more than 30 years of membership. The political fallout is just beginning, with pro-remain British Prime Minister David Cameron resigning, effective in October and "Article 50" -- the EU's exit clause -- yet to be invoked by the British government. The prior example we have was Greenland's 1982 decision to exit the EU's predecessor after a popular referendum vote for independence. After much wrangling over fishing rights (an industry responsible for the vast majority of the country's economy), it finally left in 1985 under the Greenland Treaty. It took more than 100 meetings and three years to extricate a frozen island of 56,000. How long would it take a developed island of 65 million? Long enough not to ever happen is one distinct possibility. This is going to be geopolitics in a blender on a boat at night during a hurricane. Anyone who wants to board the next elevator to the future, press C for crazy, confusing and confounding. Don't believe everything you read about what's coming. No one really knows. When the final bell tolled on Friday afternoon, the Dow Jones Industrial Average logged a loss of 3.4%, the S&P 500 lost 3.6%, the Nasdaq Composite lost 4.1%, and the Russell 2000 lost 3.8%. Treasury bonds rallied, the dollar was stronger, gold rallied 4.7%, and crude oil lost 4.8%.
Financial stocks led the decline, falling 5.4%, followed by materials and technology. Defensive telecom stocks limited their decline to 0.9%. JP Morgan (JPM) fell nearly 7% to collapse out of its three-month consolidation range and put an end to its five-month uptrend. The smackdown came despite aggressive efforts by central bankers and other policy officials to bolster sentiment overnight with promises of dollar swap liquidity and reassurances to lean against chaotic currency market volatility. Suddenly, top monetary officials like Federal Reserve chairman Janet Yellen and European Central Bank chief Mario Draghi look impotent in the face of a popular repudiation of top-down elitism. To say the result was unexpected is a massive understatement. Betting markets had the odds of remain at around 90% on Thursday. The Dow Jones Industrial Average enjoyed a surge back above the 18,000 level into the close. Early Friday morning, the smell of panic was in the air. The vote was seen as a repudiation of the post-war era of globalism driven by anger over immigration, stagnant economies, and unaccountable bureaucrats in Brussels. The CBOE Volatility Index (VIX), Wall Street's "fear gauge," posted its fifth largest gain on record after trading in U.S. equity futures was halted overnight. The Nasdaq Composite suffered its largest rout since 2011 and is now down 6% for the year. The gap down at the open was the U.S. market's worst since 1987, a sign of fragility and lack of liquidity. Gold's 4.9% surge was among its biggest days since Lehman Brothers failed in 2008. The British pound dropped to levels not seen since the mid-1980s. European bank stocks, the epicenter of all of this because of their European bond holdings and exposure to the local economy, were crushed. A surge in the Japanese yen smashed popular currency carry trades and torpedoed the Nikkei 225 index to a loss of 1,286 points or a stomach-churning 7.9%. Greek stocks lost nearly 16% while Italian stocks were down 12.5%. Italy is seen as a prime candidate to consider an independence referendum (along with France and the Netherlands) as pro-nationalist political sentiments rise. A breakdown in the European Union would threaten Greece's bailout programs, since a smaller Euro area would put the rescue burden on a smaller number of countries. The policy elites are in a bind. For one thing, all the obvious policy easing levers have already been pulled. The Federal Reserve has raised interest rates just one this cycle, leaving the Federal Funds rate between 0.25% and 0.50%. So there isn't much room to cut rates. Aggressive asset purchase stimulus programs have already been deployed, with the Fed holding nearly $4.5 trillion in assets vs. $900 billion back in 2008. The Bank of Japan is buying stocks via exchange-traded funds. The European Central Bank is buying corporate bonds. These both unprecedented efforts. Both have deployed negative interest rates with calamitous effect as they have pressured bank profitability by narrowing net interest margins. What is left? The outright purchase of individual stocks? In the case of the Fed, it's forbidden. Not so overseas. This all comes at a time of global economic vulnerability. Here in the United States, we're in the midst of an earnings recession with S&P 500 income down for the last four quarters in a row. Deflation is a real threat, made worse by elevated public debt-to-GDP ratios in the developed world. Spain, Poland, Greece, Italy, Switzerland, and the Euro area as a whole are all in outright deflation. France, the Netherlands, Ireland, Germany, the UK, and Finland all have inflation rates near 0%. Italy, a too-big-to-fail eurozone country, is among the worse off -- suffering from a 11.7% jobless rate and a 133% debt-to-GDP ratio. Spain is carrying a 99% debt ratio and a 21% jobless rate. Even France has a 96% debt ratio and a 10.2% jobless rate. In Asia, China is contending with a slow-burn credit crisis by attempting to manage down its currency in an effort to bolster exports. A collapse in the British pound and the euro threatens that effort and could unleash outright currency manipulation and a good old fashioned mercantilist foreign exchange war. Japan is a mess, with a 229% debt ratio, a 6% budget deficit, deflation, and an economy on the verge of contraction as officials obsess over keeping the yen weak in a similar effort to bolster exports. And finally, any policy response is likely to only deepen the problem. If central bankers support markets here -- keeping stocks in the low-volatility sideways crawl of the last three months, capping a three-year consolidation near Dow 18,000 -- it will prove all the pre-Brexit fear mongering hollow and will encourage pro-independence votes in Italy and elsewhere. Spain is holding new general elections on Sunday with the anti-bailout Podemos party ascendant. But if policymakers let markets fall, volatility will beget volatility as one of the few bright spots in the global economy darkens. Years of central bank intervention and easy gains have encouraged risk taking and leverage accumulation in the United States. The collapse could be swift and severe, which is why it probably won't happen. The monetary policy elites got that way by being savvy, cunning, and self-interested.. They will fight the onslaught with all they've got. Don't count them out. * * *
BREXIT UNPLUGGED Technology firms have really been dreading Brexit. Now that it’s here, the heavy lifting begins and many sore backs are likely. Although the idea of stitching together disparate European countries was always a long shot – after two thousand years of nonstop fighting – the hope among tech business leaders was centered on strength in numbers and single market access. Great Britain has never been a good fit for this model. Britons have always had a healthy skepticism about Europe. Even as it joined the European Union in the 1990s, it refused to give up control of its borders and currency. Given the immigration and debt crisis that followed, that was prescient. Despite flaws in execution of the EU, international business bought in. Companies set up shops in business-friendly London and plotted growth strategies across the continent. Friday morning, that bridge to Europe’s single market fell down. For large technology companies this is especially troublesome. Amazon (AMZN) expanded aggressively into England, spending $6.3 billion to build out its logistics operations. From its London hub the plan was to easily ship products across all of Europe. Along with Facebook (FB) and Alphabet (GOOGL), Microsoft (MSFT) and eBay (EBAY), it was working hard to do the same with digital goods and services. Big American tech companies were pushed into unlikely alliances as they fought inward-looking EU bureaucrats. Despite the name, their Digital Single Market erected new regulations for e-commerce, digital streaming and user privacy for non-European digital platforms. In this fight, pro-U.S. business forces in the UK were allies. With Brexit, that ally is dead.  Brexit is going to make it much harder for big American tech companies to do business in Europe. EU mainstays Germany and France have always been more protective of European companies. In the wake of Brexit they’re likely to flex their muscle, quickly making an example of the Brits and their allies. Companies like Google, which is currently under the watchful eye of European Commission regulators, may be in for a rude awakening. Some political scientists have made the case the only real loser is Great Britain. Already there is talk about big banks moving their headquarters from London to Frankfurt and some technology firms are understandably curtailing investment as the dust settles. Even the fear of losing these high paying jobs and investment should be enough to kill the red hot London housing market where speculators have pushed prices 10.1% higher since 2015. It’s unlikely the EU will be sympathetic. Brexit sets up possible exit votes in France and the Netherlands where far right political groups are pushing for closed borders and more strident Nationalism. It’s a scary time for businesses, which prefer the status quo. The idea of the EU was stitched together through necessity. The countries needed a single market to survive in the global marketplace. Governments wanted a good reason to stop bludgeoning each other after two world wars. Companies bought in. Even the UK bought in, for a while. And now? Hedge fund pioneer George Soros suggests the failure of the union will bring a worse outcome than if it had never happened. That's probably overstating the case, but who knows -- he's awfully smart and experienced. Although we are at the start of an amazing era of innovation, American technology companies that made large investments in Europe are likely to suffer setbacks. Yet the big trend is definitely up. Adaptive, ambitious companies will pick up the pieces and be stronger for it. As always, the strong will survive and the weak will be exposed.
* * * BREXIT WINNERS AND LOSERS The smart analysts at Convergex in New York put out a useful note on Sunday. Here is a condensed, mostly verbatim version of the views of Nick Colas: -- "The world is a very different place post-Brexit vote, and it will take time to understand all the ramifications. If a butterfly flapping its wings in Thailand can cause a hurricane in the Atlantic, what does a tornado of discontent in Britain mean to the global investment climate? We’re about to find out. -- There’s an old saying in financial circles that “Capital goes where it is most welcomed”. After the shock of the Brexit vote, that list of destinations with a “Vacancy” sign seems short indeed. Here are a few: -- -- The dollar. The greenback in its current Federal Reserve-backed iteration has been around for over a century, giving it a solid history as a crisis currency. In addition, there are over $1 trillion in hundred dollar bills in circulation around the world. And there are very few places, if any, around the world where a crisp $100 bill doesn’t get you a good meal and a clean hotel room. While the physical cash market doesn’t set prices, it does set tone, especially in chaotic times. -- -- U.S. Treasuries. Unless you want to carry your currency in an aluminum briefcase with a handcuff, buying dollars generally means buying U.S. sovereign debt. And unlike German or Japanese government debt, every U.S. Treasury security still pay a positive yield. Very welcoming indeed. -- -- Gold (but with a caveat). The yellow metal had a good day on Friday and now sits at two-year highs. It clearly benefits from the current uncertainty, centered as it is on the value of fiat currencies like the British pound. At the same time, gold is priced in dollars so strength in that currency makes it more expensive around the world. That’s bad for demand, of course. The other warning: U.S. listed exchange traded funds (IAU and GLD) now own more physical gold than all but seven sovereign nations. That ties gold demand to brokerage account margin calls, especially during periods of heightened financial market volatility. -- -- U.S. Stocks (but with even more caveats). Make no mistake: the bull story for U.S. stocks is about lower interest rates, not improving corporate fundamentals. Declining long term rates in 2016 have put a floor under domestic equities. Further declines in the 10-Year Note as low as a yield of 1% keep that narrative afloat. -- The wrinkle here is we’re talking about relative performance, of course. U.S. stocks have their own challenges, chief among them the stronger dollar. With an estimated 50% of revenues for large public companies coming from offshore economies, that is a clear headwind. There is also the natural risk-off tendency for stocks of any global market to decline under macro duress. So while U.S. stocks should outperform European, Asian and emerging economy equities, don’t look for positive absolute returns. “Down less than rest-of-world” is the new up. I'll keep your abreast of Convergex's view as it evolves. * * * IRELAND AND RUSSIA Now some last thoughts from canny market veteran Larry Jeddeloh, head of the excellent boutique research firm TIS Group, which provides global economics and investment research to institutional clients. He argued the following Sunday night (abridged but verbatim): -- "One winner is Dublin and perhaps all of Ireland. Last week, while discussing Brexit, I was told London law firms are rapidly registering in Dublin, as well as setting up offices there, in order to continue practicing with EU clients. Dublin real estate, which was decimated in 2008-2009, never really recovered and the amount of new building which has taken place, was low. It is a much shorter flight from London to Dublin (about 50 minutes), vs. a London-Frankfurt commute which is 90 minutes and you end up in one of Europe’s largest airports in Frankfurt. I think Irish property may be a place to start looking. -- A second big winner is Russia and Mr. Putin’s foreign policy. Russian investment banks and even some advisers to Putin are saying this is the end of Anglo-Saxon influence on Europe. This is important for Russia if it turns out to be true, as the UK has been instrumental in invoking EU sanctions against Russia. Without UK pressure and the U.S. being capable of exerting pressure thru the UK, Russia’s economy has an opening here. I believe Germany and certainly some German companies have wanted better relations with Russia, for some time. This may be the break the Russian economy needs. -- In terms of Putin’s foreign policy goals, Brexit opens the way for faster development of Eurasia, which in my view has been the goal for years. Russia’s economic future is East, not West, but its security risk is West rather than East. The last thing some in the West want to see happen is a China-Russia economic link forged through Eurasia, where resources are plentiful, populations growing, and billions of Dollars of investment are needed along with the expertise to build out the infrastructure. These are things China and Russia are good at and it helps complete the walling off of the East from the Western systems. -- A third winner will be the UK. After an initial period of adjustment, which may be severe, the UK will eventually become Europe’s fastest growing economy, especially if it ends the EU regulations which never helped the UK economy. This will bring investment in, pound sterling will firm and as long as the courts, property rights and taxation are well behaved, the UK will flourish. The quicker the UK moves the better. Corporations will not invest until the playing field is better defined. The global economy will suffer, for a while, as some corporate spending plans go on hold." * * * RECOMMENDATIONS Our Strategic Attack -- a combination of MacroSwitch, Yield Seeker, and Strategic and Persistent Value results – sank 1.5% on Friday, less than half as bad as the market. Click here to view all buy lists. -- MacroSwitch is neutral. The system is up 14.5% since Sept. 1 last year, vs. 4.9% for the SPDR S&P 500 (SPY) and -1.3% for the Russell 2000 (IWM). Times like this really reveal MacroSwitch's worth. Keep holding the cash. -- Yield Seeker was flat, Strategic Value fell 1.5%; Persistent Value fell 3.8%. The new PV portfolio for the summer quarter will come this week, now that prices are lower. -- I have tucked away the list of the Clews-like stocks for you, described Thursday, in a portfolio priced at Friday's close. I will let you know how they are doing. The utilities, consumer staples and REITs actually fared well Friday. Last call: We argued there would be a difficult passage into the end of the month, which is a period when companies cannot execute buyback programs ahead of the close of Q2, and are not disappointed. Expect more of the same as the world starts to adjust to a new economic reality inspired by Brexit. I suspect there will be a multiday slide before prices adjust. There will be rally attempts, potentially big ones, but they're likely to be rebuffed for awhile. Recovery from a hit this hard takes time. Thanks for reading. See you again on Monday night.
To renew, visit your Account settings. If you need assistance or have questions, email us by replying to this letter or call 206 651 4566Author: Jon D. Markman
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