Post-Brexit Q&A

Blue Quadrant Research Team
Market Commentary

A Post-Brexit Q&A with Blue Quadrant Capital Management

The month of June saw some extreme volatility in financial markets, particularly following the surprise UK referendum result. How did the funds managed by Blue Quadrant perform?

Our funds are likely to report a drawdown of between 8% and 12% for the month of June in Rand terms. This was in part driven by the relative strength in the Rand, which despite the negative global developments, actually gained ground against most major currency crosses during the month. Our funds have between 50% and 90% invested in offshore markets, mainly in the US.

We also have a large weighting in US financials, which were disproportionately impacted by the Brexit vote and contagion fears stemming from the very large price declines in UK and European financials.

Has the Brexit vote changed your thinking in terms of your existing allocations?

No. Our allocations, for the most part, are based on longer-term fundamental views. In the case of US financials, they continue to trade at valuation levels towards the lower-end of the range observed over the past three decades. We also remain encouraged regarding the scope for a continued recovery in the US economy and see no reason to expect a downturn in the US credit cycle anytime soon.

So you remain positive on the US economic outlook and credit cycle despite the recent Brexit outcome?

Indeed. As we have noted in prior publications, US household leverage (debt to disposable income) has decreased since 2008 and coupled with still very low-interest rates, debt service obligations remain near multi-decade lows. Together with continued wage and employment growth, it is very difficult to make a case for a retrenchment in US consumer spending and by implication the broader economy (US consumption spending accounts for 70% of US GDP)

It is also very difficult to make the case for a sudden or sharp increase in consumer delinquency rates in the US and/or contraction in credit growth. This environment is still a generally supportive for financials and as such the current valuation disconnect (current valuations seem to be pricing in another recession or perpetual zero or negative rates) is still very appealing to us from a risk/reward perspective.

But isn’t there a risk to the US economy if the UK and European economies move back into contraction?

The UK economy in isolation is small (3.7% of global output) and US exports to the UK are essentially insignificant. So even a deep recession in the UK would, in our opinion, have little real impact on the US economy. The UK economy will also have little impact on global commodity demand, where China remains the key player.

However, a deep recession in the UK would negatively impact the EU and this is where the risk probably lies. Nevertheless, in direct terms, UK imports from the EU are not that significant. Germany (accounting for nearly 50% of EU exports to the UK) would be most affected. However, domestic demand is continuing to gain traction in Germany, with unemployment at the lowest level in two decades and wage growth accelerating. Property prices also continue to move higher after years of stagnation following reunification in 1990.

As such, our base case is that the European economy will not enter another recession although growth may slow over the next 6 months. If anything this will ensure that the ECB remains very accommodative despite a likely acceleration in European CPI going forward (as the base effects from last year’s decline in the oil price come into play).

If anything, the Brexit outcome, at least over shorter-term, will increase the likely economic and hence policy divergence between the US and Europe.

Ok. But this suggests more US Dollar strength going forward, which will cap inflation in the US and keep the Fed on hold for now. Also, a stronger USD has typically been negative for EM, commodities and financial markets in general?

It has, but I think we should take note of the recent resilience in commodity prices. It is telling us an important story that perhaps supply-side cuts are starting to overwhelm weak demand-side dynamics. We feel this is particularly relevant in the energy sector, where global oil production is now in decline. US oil production as an example is down by 1mn barrels/day since reaching its peak in early 2015.

Stable or rising commodity prices will support EM dynamics and in particular EM commodity producers.

So perhaps a stable US Dollar vs. EM currencies but still appreciating vs. GBP and EUR?

Yes perhaps, or at least over the next 6 – 12 months. We continue to see scope for US/EU policy divergence to push the USD/EUR cross towards parity, a long-standing target we have had. At the margin, slowing European growth and a recession in the UK will push out any Fed rate tightening for 3 to 6 months, but if commodity prices and EM currencies remain stable or even appreciate in the context of continued US growth, Fed tightening could be back on the table, more quickly than many now assume.

What about the Pound?

We think the Pound has further to weaken, even from current levels. We have long held a negative view on the UK economy given the imbalances that have built up in the British economy over the past decade. A very large current account deficit coupled with the twin risks of an over-sized banking system (relative to GDP) and inflated property prices was always going to be a recipe for a potential vicious economic dislocation at some point, Brexit or no Brexit.

So the Brexit outcome has not really changed your outlook on the UK economy?

Not really, it has only increased our conviction on our negative view and, in particular, our negative view on the UK property and financial services sectors. We think there is a non-trivial risk that London property prices could fall 30% – 40% over the next few years and we ultimately see scope for the Pound to fall to parity to the US Dollar.

That is quite significant, yet you are still able to retain a generally positive view on global or at least US equities?

As we have said before, the UK economy in isolation is small and will not significantly impact the global economy. As an example, the Brazilian economy has been in a very deep and prolonged recession over the past two years (the most severe in two decades) and it has had no impact on US economic growth. The UK economy is only 60% larger than the Brazilian economy. Let us also remember that the US economy in total is more than 6 times as large as the UK economy. What happens in the US and China and to a lesser degree the EU as a whole, is all that really matters in terms of the global economic outlook.

Let’s also be clear, that we are not positive on equities in general. Certain sectors such as financials and commodity producers offer value. Excluding these sectors, in the US at least, equities are quite expensive on a relative basis. This is particularly the case with regard to consumer staples, which have benefitted in recent years and over the past month from the “search for yield” dynamic given their perceived steady dividend yields.

What about the global political landscape in general? Some investors are starting to fear that a broader rise in populism in developed countries could unravel global growth prospects?

It is certainly a risk. The election of Donald Trump in November and to the extent he is allowed to implement some of his more protectionist policies would be a much greater risk to global growth and by implication global equity markets than the Brexit vote. Fortunately, the US political system is designed with greater checks and balances on executive power. This will make it difficult for Trump to enact some of these policies without the backing of Congress and specifically the entire Republican party, where a large faction of house and senate members will undoubtedly push back on protectionist policy.

In the final analysis, the unraveling of globalization and the implementation of protectionist policy is stagflationary, not deflationary. Rising tariffs would lead to higher inflation in economies such as the US, even if growth remains weak. This is not a great environment for bonds and will also be a negative environment for global multinationals, particularly consumer staple companies. In an environment of rising commodity prices and wage inflation, the double whammy of an increase in import tariffs could severely impact profit margins for these companies.

Again, we think in this kind of environment commodity producers and to a lesser extent financials (who can still benefit from higher interest rates) will actually prove quite defensive. For more risk averse investors (not seeking exposure to equities) we would recommend moving out of developed market bonds and corporate bonds and would suggest allocating capital to inflation-protected bonds (TIPS). In a stagflationary environment, where inflation is accelerating due to protectionist policies, but nominal rates are still being suppressed by central bank actions, TIPS could perform very well and offer a decent hedge against an unchecked rise in populist policy or “Trumpism”.

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