Anatole Kaletsky’s book was the source of much heated debate. And it is probably through the prism of this belief in the technocratic classes that investors’ reaction can now be judged. Indeed, there are two possible logical reactions to the Brexit vote:
1) Following Brexit, OECD policymakers will redouble their market price manipulation efforts. We should thus expect more QE, more ZIRP and NIRP for longer, including perhaps from the US. In this environment, there are few reasons to believe that the US dollar will surge (somehow still a core market belief—and on that note, we would highlight that, devastating though news of Brexit was for the overall European Union, the euro has yet to flirt with the lows seen in March 2015).
As the Federal Reserve goes back to sitting on its hands, and the US dollar continues to range-trade, emerging market central banks (which saw monetary conditions tighten in relative terms between 2011 and 2015), will now cut rates as aggressively as everyone else. EM bond yields will collapse, while commodities will continue to hold up (interestingly, unlike in 2008, oil did not fall hard on Friday) and gold will continue to outperform.
In this environment, EM in general will catch back their five years of post-2011 underperformance (when EM and OECD central bank policies diverged).
2) Following Brexit, policymakers will freeze like deer in headlights and start to accept that the policies they have followed, by exacerbating wealth differences, have set them straight on an electoral hiding to nothing. Worse, the technocratic classes may start infighting in a bid to survive (for example, in an attempt to punish the UK, they could impose tariffs and fall back into protectionism). Alternatively incumbent politicians could lose elections and be replaced by a new breed, as we are witnessing in England, and also possibly in Italy (with the election of Five Star mayors in Rome and Turin — wealthy Italian cities not usually associated with the perceived reprobates who voted “Leave” in Britain) and to an extent in Spain (although the radical Podemos party performed less well than expected in Sunday’s election, the vote seems to have solved little. Spain appears as ungovernable now as before the election). And the purpose in life of this new political breed will not be to underwrite the price of financial assets (whether bonds, real estate or equities) and to prolong the status quo. Needless to say, in this scenario (the scenario that most investors fear today), overvalued assets dependent on central bank liquidity are very much at risk.
These include eurozone peripheral bonds, JGBs, real estate in most financial centers (whether London, New York or Hong Kong), the equity value of banks (as banks could easily be nationalised) and of course US equities (where relative valuations remain very punchy).
Unfortunately, as Anatole Kaletsky pointed out on Friday, the visibility between these two alternative paths is clouded at best, as so much will depend on policymakers’ responses, and on the ballot-box. Worse still, opinion polls and betting lines may prove to be very imperfect guides, as was shown Thursday night. Given the uncertainties surrounding the Spanish, French, German and US elections, this new reality will most likely curtail animal spirits among entrepreneurs and businessmen over the coming months (at the very least). With that in mind, investors should look to concentrate their portfolios on asset classes that do not risk decimation should one, or the other scenario unfold.
To start with, this means avoiding any asset trading above its historical long-term valuation (unfortunately, today this includes most OECD government bonds, OECD equity markets and OECD real estate markets, as the whole point of the recent policy was to boost OECD asset prices). It also means acknowledging that gold, as one of the few asset classes that benefits from either scenario, is now in a structural bull market.
Finally, it possibly means concentrating on owning assets that could potentially benefit from new monetary and fiscal stimulus without being unduly penalized by OECD policy uncertainty (EM equities? EM bonds? EM currencies? Canadian equities and the Loonie?).