Back on the 16th of June I wrote an article to you called “Brexit or Bremain: how to play it”. The opening few paragraphs were:
Brexit or Bremain, the outcomes are polar opposites for risk asset markets and today I want to run through what this all means ahead of the UK referendum on the 23rd of June.
Firstly, make no mistake, this is turning into MAJOR market event. Either outcome will move markets sharply and we need to be prepared for volatility. I did write recently to you that I had built up cash levels waiting for a pullback, and I did point to Brexit as one of the reasons for building up cash and waiting for better risk adjusted entry prices.
This is NOT a game like Grexit that was always going to end with Greece folding & markets bouncing. This is a genuine 50/50 chance in my opinion and that is how I am positioning my portfolio. No outcome is certain and arguably the only certainty is volatility ahead of and after the referendum. If anything, recent opinion polls show the Brexit camp pulling ahead and bookmaker odds, while still favouring Bremain, have narrowed a notch.
It’s worth remembering the referendum is NOT a compulsory voting situation and occurs on a Thursday, again decreasing the forecastability of the event as voter turnout is unknown. It’s also potentially a vote based on emotion rather than economics and that makes it a potentially dangerous event for market participants.
Fast forward to today and “emotion” clearly beat “economic sense”. The consequences have been rightly severe for anything directly or indirectly related to the United Kingdom, led down by the British Pound (GBP).
Brexit is clearly a textbook “black swan” event. The day before the referendum the bookmaker odds and risk market pricing had “Bremain” priced in as a certainty. Not a favourite, a certainty.
Unfortunately, and the reason the market reaction was so negative, was that it appears that just about nobody expected, or was positioned, for “Brexit”.
Perhaps that can be explained by the graph below, which shows the dominant “Bremain” vote was around the City of London and nearby jurisdictions. Outside of those areas it’s a sea of red voting to leave the EU.
It now appears clear the City of London, the financial centre, grossly misread the situation due to their own economic rationalism and self-interest favouring “Bremain”.
The UK and Europe now faces an extended period of UNCERTAINTY as the UK negotiates its exit from the EU. This will clearly suppress economic activity in the UK and Europe for years to come. It’s particularly bad for banks and investment banks as corporations mothball any capex plans due to uncertainty and further Pound devaluation risk.
The biggest negative price reaction to this genuine “black swan” event has been in UK and European Banks, followed by listed asset managers.
To see the European Stoxx600 banking index down -21.1% is a genuine crash and trying to tell you this is a very serious event with short, medium and long-term consequences.
No doubt there will be bounces in these banking stocks in the days and weeks ahead, however, the damage is done and it is trying to tell you Brexit is a major UK, European and global economic and sentiment event. It will no doubt lead to risk premium rising and global growth rates being revised down. It will also lead to central banks lowering cash rates again, including the RBA in August.
The ONLY positive I can take from this “black swan” event is that global interest rates will remain at historical lows. You can forget the Fed raising rates this year, in fact Fed Fund Futures now price in a 20% chance of the Fed CUTTING rates this year. That’s an amazing reversal of market pricing and again confirms how serious and enduring bond markets feel this event is.
But central banks are broadly out of bullets. With the notable exception of the RBA and BNZ, the entire central bank world is basically at 0% cash rates, trying to devalue their currency, and doing some form of quantitative easing (QE). Central Banks are pushing on a string, and setting any investment strategy based on central banks coming to the rescue is flawed in my view. Yes, they could cause a short-term sugar hit, but as we’ve seen in Japan, negative cash rates caused the Nikkei to crash because of the profit effect on banking stocks and a totally unexpected rally in the Yen (JPY).
As I have written for ages, falling long government bond yields are telling you to hunker down for an extended period of very low interest rates, very low inflation and very low global growth. Bonds have been right in forecasting what we see in front us today, and in forecasting low returns from risk assets.
While most people focus on equities only, I look at the bond markets for a guide to where we should and should not be investing in equities and also for a guide to what overall returns we should be generating for taking risk.
The chart below graphs the US 10yr Bond (white) vs. the US S&P500 Index (yellow). It would suggest bonds and equities are pricing in two completely different medium-term economic scenarios and that is a situation that can ONLY drive further volatility and sentiment swings.
It’s also worth noting the MSCI All World Equity Index (MXWO) has broken below its 200-day moving average. This chart may well be telling you the MXWO has peaked for this cycle.
What this is telling is NOT to expect a rising equity market tide to lift all ships. In fact, the broader equity tide may well continue to go out (down) if the bond markets are proved right in their pricing expectations.
However, as I always say, it’s a market of stocks not a stock market and I continue to run my fund with a clear Growth, Income & Protection strategy. I call it G.I.P and in times like this the G.I.P strategy is delivering outperformance.
I want to own companies that are growing organically or via a sensible acquisition strategy in sectors with structural growth sectors. I want to own non-financial dividend growth stocks, and I want portfolio protection via index puts, index futures shorts and gold longs. That is the combination I believe will drive outperformance of benchmarks in the short, medium and long term.
For Australian investors I can’t stress enough the importance of dividend growth/reliable dividend stocks in this environment. I strongly believe dividend yield plus franking credits will drive the vast bulk of total return form Australian equities.
The key Australian stocks the AIM Global High Conviction Fund holds on this theme, or intends to buy during further market weakness, include Transurban (TCL), Duet (DUE), Sydney Airport (SYD), Telstra (TLS), and Southern Cross Austereo (SXL).
In terms of Australian listed structural growth stocks, the key stocks the AIM Global High Conviction Fund holds or intends to buy during further market weakness include Link Group (LNK), Star Group (SGR), Aristocrat (ALL), Baby Bunting (BBN), and Treasury Wine Estates (TWE).
All in all, it seems very clear to me that we must be prepared for further volatility. By volatility I mean genuine swings between hope and fear. There will be relief rallies/dead cat bounces followed by down days. It may well feel like being in the spin cycle of a washing machine but that is the standard market response to what is a genuine “black swan event”. This volatility will most likely be around until the US Presidential election is resolved, another potential “black swan event”.
However, there is clear opportunity in volatility and I will continue to attempt to point out where I think that opportunity is at a stock specific level as we move through this difficult times in markets.
God save the Queen, because nothing will save the Pound…
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.