It was undoubtedly a surprise when 52% of the British electorate voted to leave the European Union. The immediate reaction of international investors was flight into safe haven assets – US and German government bonds – and a sell-off in equities and property. Investor reaction reflected a view that the British electorate favoured a path of change and this change is associated with uncertainty, which will undoubtedly drive volatile market behavior.
Following the initial knee-jerk reaction, however, the Japanese equity market is up by ~10% since its post-Brexit lows, the broader US equity market is recording new daily highs and even European equities have recovered markedly from their lows. Yet, safe haven assets, government bonds, have continued to trade at record high levels. It must be very confusing to investors that safe haven assets and risky assets can at the same time attract demand and high prices from investors. How can we explain it and how do we interpret this phenomenon in our client portfolios?
The initial sanguine behaviour of investors can be ascribed to a number of factors. The Brexit vote will have political and economic implications. However, it did not cause a financial crisis, as central banks were generally prepared for the Brexit vote and the banking system could accommodate the immediate demands placed on it. First, the Bank of England opened extra liquidity windows for the UK domestic banking system. The sterling market provided global investors with highly effective means of hedging UK risk. Second, the economic shock is likely to be largely limited to the UK economy. Third, it’s also clear that the Bank of England is likely to target economic growth as its number one objective when it crafts future policy measures.
For a longer-term view, it is more difficult to explain the price gains in both safe haven assets and risky assets. Or to put it more simply, it’s difficult to explain the conflicting message conveyed by bond markets and equity markets respectively. The bond market would argue that the Brexit shock is worrying as it came at a time when global growth and the financial environment were already in a very fragile condition. We have commented in previous publications that we believe globally economic activity is stuck in a low-growth rut. In our view, the level of bond yields is consistent with low growth and thus a low-inflation world where there is structural weakness in private sector credit demand, which most governments are reluctant to offset with major fiscal stimulus. In other words, bonds are discounting an uninspiring rather than calamitous economic outlook. Having said that, it’s hard to see inspiring returns from this asset class internationally, except if the world goes into deflation, which is not our base case view.
An uninspiring economic environment begs the question of why equities aren’t faring worse. Globally, and in the US in particular, corporate earnings rose despite a weak economy and that, together with low interest rates, underpinned stock prices. Earnings were less buoyant in other major economies, explaining why the US market was the star performer. Over the past year, earnings have struggled. However, low bond yields continue to provide support to equities as the search for yield remains a powerful force supporting risk asset prices. Our sense is that investors globally were already positioned for low economic growth and low profit growth.
This remains a rather precarious situation for equity investors although we are not in the camp of long-term equity bears. Cautious investors will argue that if we don’t get a positive economic surprise that will boost earnings growth, equity investors are dependent on the yield argument for continued support. It is partly true but we believe equities still deserve their rightful place in longer term investment portfolios for various reasons.
As we have argued earlier, the very low bond yields of trustworthy sovereigns hardly provide a long-term viable investment alternative. Although equity valuations are not cheap in terms of their own history, neither are they expensive. An investment in a company with a growing income stream would ultimately lead to capital growth if the starting base is not expensive.
This constructive stance should not be confused with high return expectations. A low- growth environment is hardly conducive to strong earnings growth. However, as monetary policy has been focused on trying to encourage more risk-taking, it will undoubtedly help support equity markets.
We will become more positive about the return of equities if there are enough new policy stimuli to pull economies out of their current growth rut. Until that occurs, we recommend a balanced approach to an investment portfolio. For some investors this a luke-warm outlook, which is rather frustrating. Unfortunately, this situation is reality and it is our challenge to navigate through it. We have no doubt markets are likely to continue to be volatile, which will provide opportunities to buy attractively priced assets and sell expensive ones.