A Brexit in­duced re­can­ta­tion

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Ex­actly two months have now passed since the Brexit ref­er­en­dum. Af­ter tak­ing a long hol­i­day to re­cover from the shock and re­gain some per­spec­tive, it is now an ap­pro­pri­ate time to re­view what has hap­pened, and what hasn’t, since June 23. As a quin­tes­sen­tial mem­ber of the met­ro­pol­i­tan, in­tel­lec­tual, im­mi­grant, mon­eyed elite that was an­grily re­pu­di­ated by a ma­jor­ity of Bri­tish vot­ers, this ref­er­en­dum was a pro­found emo­tional trauma. It may not be sur­pris­ing, there­fore, that my ini­tial re­ac­tion as the hor­ri­fy­ing (to me) re­sults were still com­ing over the news wires, turned out to be com­pletely wrong.

Con­trary to my emo­tion­ally-charged pre­dic­tion that Brexit would pre­cip­i­tate a po­lit­i­cally-driven global bear mar­ket, al­most all as­set prices have risen sub­stan­tially in the past two months. In­stead of pan­ick­ing about the start of a pop­ulist anti-glob­al­iza­tion back­lash, in­vestors around the world have treated Brexit as a non-event, pre­fer­ring to fo­cus, as I did my­self un­til the Brexit vote, on the fact that eco­nomic and mon­e­tary con­di­tions re­main re­mark­ably be­nign and sta­ble, es­pe­cially in the US. As a re­sult, eq­uity prices have risen strongly not just in Amer­ica, Europe and emerg­ing mar­kets, but also in Bri­tain, where the do­mes­ti­cally-ori­ented FTSE-250 mid-cap in­dex has re­bounded al­most as strongly as the ster­ling-sen­si­tive FTSE 100. Last Mon­day, both FTSE in­dexes peaked (tem­po­rar­ily?) within 3% of their 2015 all-time highs.

In fact, only two im­por­tant prices—ster­ling and yen— have moved in the ex­pected di­rec­tion. And even these moves have been much less dra­matic than an­tic­i­pated, con­tin­u­ing for only two weeks af­ter the Brexit vote. Since the first week of July, both ster­ling/dol­lar and dol­lar/yen have set­tled into nar­row trad­ing ranges with­out much sign of fur­ther panic or mar­ket pres­sure. The euro, even more sur­pris­ingly, has been en­tirely sta­ble, worth ex­actly the same to­day against the dol­lar (US$1.13) as on the day of the ref­er­en­dum, when the mar­kets con­fi­dently ex­pected Re­main to win.

Why did my ex­pec­ta­tions of a global bear mar­ket caused by the pol­i­tics of the Brexit vote turn out to be so wrong, as did the many pre­dic­tions of fa­tal dam­age to the euro­zone? There seem to be four broad ex­pla­na­tions, none of which jus­tify my ini­tial over-re­ac­tion, although the last one does sug­gest that cau­tion about the present risk-on en­thu­si­asm may still be ap­pro­pri­ate, es­pe­cially in the next two months.

1) Eco­nomic data has been even more sup­port­ive of an eq­uity and euro rally than it was prior to June 23, when I was a card-car­ry­ing mem­ber of the risk-on fac­tion. China, the euro­zone and Bri­tain it­self have de­fied bear­ish eco­nomic pre­dic­tions that were so preva­lent in the first few months of the year. But the most im­por­tant news for the mar­kets is al­ways about the US econ­omy and the data re­leased since June 23 has been es­pe­cially en­cour­ag­ing. It is no co­in­ci­dence that the post-Brexit slump in ster­ling abruptly re­versed and the S&P 500 broke out to new record highs af­ter the July 8 US pay­rolls. This re­lease re­futed fears of a US re­ces­sion and con­firmed the seem­ingly un­break­able link­age be­tween short-term volatil­ity in monthly pay­rolls and global equities. It was also help­ful that Chi­nese and Euro­pean Union fig­ures since June 23 have been de­cent and no UK of­fi­cial data has so far con­firmed the col­lapse in con­sumer and busi­ness con­fi­dence im­plied by sur­veys.

2) In­vestors can thank their lucky stars for mon­e­tary pol­icy. The com­bi­na­tion of de­cent US-led global growth with Brexit-linked un­cer­tainty about the fu­ture has trans­formed “lower-for-longer” into “lower-for­ever”. The Goldilocks com­bi­na­tion of steady growth with low in­fla­tion can no longer be dis­missed as a fairy tale and now looks like a per­ma­nent way of life. In the post-Brexit world of pre­vi­ously un­think­able events, neg­a­tive in­ter­est rates no longer seem sur­pris­ing, or even un­usual. NIRP ter­ri­fied in­vestors in Europe and Ja­pan a few months ago; but now it is ac­cepted as a per­ma­nent fea­ture of the “New Nor­mal” and banks are ad­just­ing their busi­ness strate­gies to cope.

3) The pol­i­tics of Brexit has played out very dif­fer­ently than most peo­ple, in­clud­ing me, ex­pected. In Bri­tain, a new prime min­is­ter has taken charge faster than seemed pos­si­ble. Theresa May’s abil­ity to han­dle this new job re­mains untested and she will be chal­lenged to man­age her slen­der par­lia­men­tary ma­jor­ity once Brexit ne­go­ti­a­tions be­gin. But for the mo­ment, in­vestors and pub­lic opin­ion are ig­nor­ing such de­tails, partly be­cause the Brexit time­line stretches be­yond in­vestors’ time hori­zons, as it seems pos­si­ble that the UK may de­lay the start of the two-year “Ar­ti­cle 50” with­drawal process un­til late 2017, af­ter the Ger­man and French elec­tions. If this is the case, then Bri­tain will re­main in EU un­til the end of the decade, which in terms of nor­mal fi­nan­cial timescales is al­most too far ahead to be for­mally fac­tored into cal­cu­la­tions. No­body can say at present whether this new­found in­dif­fer­ence to Brexit will turn out to be well­founded re­al­ism, com­pla­cency or wish­ful think­ing, but it is def­i­nitely not the at­ti­tude that I ex­pected in the pan­icky hours im­me­di­ately af­ter the vote.

A bored in­dif­fer­ence has also dulled in­vestor sen­ti­ment about the US pres­i­den­tial elec­tion and the prece­dent set by Brexit for the pos­si­ble dis­in­te­gra­tion of the euro and the EU. Far from con­firm­ing my pre­dic­tion that Brexit would be feared as a lead­ing in­di­ca­tor of such anti-es­tab­lish­ment up­heavals in Amer­ica, Italy and else­where, in­vestors now seem more re­laxed about pol­i­tics than be­fore June 23. Judg­ing by pre­dic­tion mar­kets and bet­ting odds, a Trump Pres­i­dency is con­sid­ered about as un­likely as a win for Brexit was two months be­fore the ref­er­en­dum. And judg­ing by many in­vestors’ com­ments, it would not make much dif­fer­ence to the US or the global econ­omy even if Trump did win. Would Trump re­ally start a trade war with China, ex­pel un­doc­u­mented im­mi­grants, sus­pend NAFTA, run tril­lion dol­lar deficits or carry out any of the other scary poli­cies that dom­i­nate his cam­paign? No­body knows and al­most no­body seems to care.

Sim­i­larly, in Europe no­body seems to care any longer about the high prob­a­bil­ity that Mat­teo Renzi will lose his con­sti­tu­tional ref­er­en­dum or that Ital­ian bank bailouts will be blocked by EU bu­reau­crats or that main­stream French politi­cians will turn ag­gres­sively against the euro to pre­vent a hem­or­rhage of vot­ers to the Na­tional Front. It could well be that none of these po­lit­i­cal shocks will hap­pen. It could be, on the other hand, that in­vestors have be­come com­pla­cent about pol­i­tics sim­ply be­cause the mar­ket re­ac­tion to Brexit has proved un­ex­pect­edly mild.

4) When the un­ex­pected hap­pens, mar­kets of­ten suf­fer a pan­icky over-re­ac­tion in the very short term, but then un­der­re­act in the medium term. The rea­son why trend-fol­low­ing strate­gies tend to work is that prices can take many months to fully re­flect big changes in the fun­da­men­tals and in­vestors of­ten spend years in de­nial about his­toric trans­for­ma­tions that al­most no­body pre­dicted or no­body fully un­der­stands. Brexit could yet turn out to have been a tec­tonic shift of this kind, es­pe­cially if it is fol­lowed by anti-elit­ist up­heavals in other coun­tries. It could be, in other words that the mar­ket’s be­hav­ior in the two months since Bri­tain’s ref­er­en­dum shock, will be no more a guide to the fu­ture than was the first few months of trad­ing af­ter the ini­tial rum­blings of the 2007 sub­prime cri­sis or the dot-com burst in 2000.

On bal­ance, a con­tin­u­a­tion of the bull mar­ket, pow­ered by the US ex­pan­sion and hy­per-stim­u­la­tive mon­e­tary pol­icy, is the most likely sce­nario for the next year or so. But with the US elec­tion and the Ital­ian ref­er­en­dum now only two months away, the full con­se­quences of Brexit be­ing hard to de­duce and eq­uity prices be­ing higher than ever, cau­tion seems more ap­pro­pri­ate than courage, at least un­til we know the name of the next US pres­i­dent on Novem­ber 8.

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