Central Bankers’ New Clothes

Central Bankers’ New Clothes

In this week’s musings:

  • Earnings Season Kicks Off 
  • Central Bankers’ New Clothes 
  • Debt Ceiling – I’m Baaack
  • Trade Wars – The Gift that Keeps on Giving
  • Domestic Economy – More Signs of Sputtering
  • Stocks – What Does It All Mean

It’s Earnings Season

Next week banks unofficially kick off the June quarter earnings season with expectations set for a -2.6% drop in S&P 500 earnings, (according to FactSet) after a decline of -0.4% in the first quarter of 2019. If the actual earnings for the June quarter end up being a decline, it will be the first time the S&P 500 has experienced two quarters of declines, (an earnings recession) since 2016. Recently the estimates for the third quarter have fallen from +0.2% to -0.3%. Heading into the second quarter, 113 S&P 500 companies have issued guidance. Of these, 87 have issued negative guidance, with just 26 issuing positive guidance. If the number issuing negative guidance does not increase, it will be the second highest number since FactSet began tracking this data in 2006. So not a rosy picture.

Naturally, in the post-financial crisis bad-is-good-and-good-is-bad-world, the S&P 500 is up nearly 20% in the face of contracting earnings — potentially three quarters worth — and experienced the best first half of the year since 1997. In the past week, both the S&P 500 and the Dow Jones Industrial Average have closed at record highs as Federal Reserve Chairman Powell’s testimony before Congress gave the market comfort that cuts are on the way. This week’s stronger than expected CPI and PPI numbers are unlikely to alter their intentions. Welcome to the world of the Central Bankers’ New Clothes

Central Bankers’ New Clothes

Here are a few interesting side-effects of those lovely stimulus-oriented threads worn in the hallowed halls of the world’s major central banks.

https://www.tematicaresearch.com/wp-content/uploads/2019/07/2019-07-12-EU-EM-Neg-Yields.png https://www.tematicaresearch.com/wp-content/uploads/2019/07/2019-07-12-Greek-below-UST.png

Yes, you read that right. Greece, the nation that was the very first to default on its debt back in 377BC and has been in default roughly 50% of the time since its independence in 1829, saw the yield on its 10-year drop below the yield on the 10-year US Treasury bond. But how can that be?

Back to those now rather stretchy stimulus suits worn by the world’s central bankers that allow for greater freedom of movement in all aspects of monetary policy. In recent weeks we’ve seen a waterfall of hints and downright promises to loosen up even more. The European Central Bank, the US Federal Reserve, the Bank of Canada have all gone seriously dovish. Over in Turkey, President Erdogan fired his central banker for not joining the party. Serbia, Australia, Dominican Republic, Iceland, Mozambique, Russia, Chile, Azerbaijan, India, Australia, Sri Lanka, Kyrgyzstan, Angola, Jamaica, Philippines, New Zealand, Malaysia, Rwanda, Malawi, Ukraine, Paraguay, Georgia, Egypt, Armenia, and Ghana have all cut rates so far this year, quite a few have done so multiple times. From September of 2018 through the end of 2018, there were 40 rate hikes by central banks around the world and just 3 cuts. Since the start of 2019, there have been 11 hikes and 38 cuts.

That’s a big shift, but why? Globally the economy is slowing and in the aftermath of the financial crisis, a slowing economy is far more dangerous than in years past. How’s that?

In the wake of the financial crisis, governments around the world set up barriers to protect large domestic companies. The central bankers aimed their bazookas at interest rates, which (mostly as an unintended consequence) ended up giving large but weak companies better access to cheap money than smaller but stronger companies. This resulted in increasing consolidation which in turn has been shrinking workers’ share of national income. For example, the US is currently shutting down established companies and generating new startups at the slowest rates in at least 50 years. Today much of the developed world faces highly consolidated industries with less competition and innovation (one of the reasons we believe our Disruptive Innovators investing theme is so powerful) and record levels of corporate debt. It took US corporations 50 years to accumulate $3 trillion in debt in the third quarter of 2003. In the first quarter of 2019, just over 15 years later, this figure had more than doubled to $6.4 trillion.

Along with the shrinking workers’ share of national income, we see a shrinking middle class in many of the developed nations – which we capitalize on in our Middle Class Squeeze investing theme. As one would expect, this results in the economy becoming more and more politicized – voters aren’t happy. Recessions, once considered a normal part of the economic cycle, have become something to be avoided at all costs. The following chart, (using data from the National Bureau of Economic Research) shows that since the mid-1850s, the average length of an economic cycle from trough to peak has been increasing from 26.6 months between 1854 and 1919 to 35 months between 1919 and 1945 to 58.4 months between 1945 and 2009. At the same time, the duration of the economic collapse from peak to trough has been shrinking. The current trough to (potential peak) is the longest on record at 121 months – great – but it is also the second weakest in terms of growth, beaten only by the 37-month expansion from October 1945 to November of 1948.

https://www.tematicaresearch.com/wp-content/uploads/2019/07/2019-07-12-Economic-Cycles.png

Why has it been so weak? One of the reasons has been the rise of the zombie corporation, those that don’t earn enough profit to cover their interest payments, surviving solely through refinancing – part of the reason we’ve seen ballooning corporate debt. The Bank for International Settlements estimates that zombie companies today account for 12% of all companies listed on stock exchanges around the world. In the United States zombies account for 16% of publicly listed companies, up from just 2% in the 1980s. 

This is why central bankers around the world are so desperate for inflation and fear deflation. In a deflationary environment, the record level of debt would become more and more expensive, which would trigger delinquencies, defaults and downgrades, creating a deflationary cycle that feeds upon itself. Debtors love inflation, for as purchasing power falls, so does the current cost of that debt. But in a world of large zombie corporations, a slowing economy means the gap between profit and interest payments would continue to widen, making their survival ever more precarious. This economic reality is one of the reasons that nearly 20% of the global bond market has negative yield and 90% trade with a negative real yield (which takes inflation into account).

Debt Ceiling Debate – I’m baack!

While we are on the topic of bonds, the Bipartisan Policy Center recently reported that they believe there is a “significant risk” that the US will breach its debt limit in early September if Congress does not act quickly. Previously it was believed that the spending wall would not be hit until October or November. As the beltway gets more and more, shall we say raucous, this round could unnerve the markets.

Trade Wars – the gift that keeps on giving

Aside from the upcoming fun (sarcasm) of watching Congress and the President whack each other around over rising government debt, the trade war with China, which gave the equity markets a serious pop post G20 summit on the news that progress was being made, is once again looking less optimistic. China’s Commerce Minister Zhong Shan, who is considered a hardliner, has assumed new prominence in the talks, participating alongside Vice Premier Liu He (who has headed the Chinese team for over a year) in talks this week. The Chinese are obviously aware that with every passing month President Trump will feel more pressure to get something done before the 2020 elections and may be looking to see just how hard they can push.

Trade tensions between the US and Europe are back on the front page. This week, senators in France voted to pass a new tax that will impose a 3% charge on revenue for digital companies with revenues of more than €750m globally and €25m in France. This will hit roughly 30 companies, including Apple (AAPL), Facebook (FB), Amazon (AMZN) and Alphabet (GOOGL) as well as some companies from Germany, Spain, the UK and France. The Trump administration was not pleased and has launched a probe into the French tax to determine if it unfairly discriminates against US companies. This could lead to the US imposing punitive tariffs on French goods.

Not to be outdone, the UK is planning to pass a similar tax that would impose a 2% tax on revenues from search engine, social media and e-commerce platforms whose global revenues exceed £500m and whose UK revenue is over £25m. This tax, which so far appears to affect US companies disproportionately, is likely to raise additional ire at a time when the US-UK relationship is already on shaky ground over leaked cables from the UK’s ambassador that were less than complimentary about President Trump and his administration.  

That’s just this week. Is it any wonder the DHL Global Trade Barometer is seeing a contraction in global trade? According to Morgan Stanley research, just under two thirds of countries have purchasing manager indices below 50, which is contraction territory and further warning signs of slowing global growth. This week also saw BASF SE (BASFY), the world’s largest chemical company, warn that the weakening global economy could cut its profits by 30% this year.

Domestic Economy – more signs of sputtering

The ISM Manufacturing index weakened again in June and has been declining now for 10 months. The New Orders component, which as its name would imply, is more forward-looking, is on the cusp of contracting. It has been declining since December 2017 and is at the lowest level since August 2016. Back in 2016 the US experienced a bit of an industrial sector mini-recession that was tempered in its severity by housing. Recall that back then we saw two consecutive quarters of decline in S&P 500 earnings. Today, overall Construction is in contraction with total construction spending down -2.3% year-over-year. Residential construction has been shrinking year-over-year for 8-months and in May was down -11.2% year-over-year. Commercial construction is even worse, down -13.7% year-over-year in May and has been steadily declining since December 2016. What helped back in 2016 is of no help today.

While the headlines over the employment data (excepting ADP’s report last week) have sounded rather solid, we have seen three consecutive downward revisions to employment figures in recent months. That’s the type of thing you see as the data is rolling over. The Challenger, Gray & Christmas job cuts report found that employer announced cuts YTD through May were 39% higher than the same period last year and we are heading into the 12thconsecutive month of year-over-year increases in job cuts – again that is indicative of a negative shift in employment.

Stocks – what does it all mean?

Currently, US stock prices, as measured by the price-to-sales ratio (because earnings are becoming less and less meaningful on a comparative basis thanks to all the share buybacks), exceed what we saw in the late 1999s and early 2000s. With all that central bank supplied liquidity, is it any wonder things are pricey?

On top of that, the S&P 500 share count has declined to a 20-year low as US companies spent over $800 million on buybacks in 2018 and are poised for a new record in 2019 based on Q1 activity. Overall the number of publicly-listed companies has fallen by 50% over the past 20 years and the accelerating pace of stock buybacks has made corporations the largest and only significant net buyer of stocks for the past 5 years! Central bank stimulus on top of fewer shares to purchase has overpowered fundamentals.

This week, some of the major indices once again reached record highs and given the accelerating trend in central bank easing, this is likely to continue for some time — but investors beware. Understand that these moves are not based on improving earnings, so it isn’t about the business fundamentals, (at least when we talk about equity markets in aggregate as there is always a growth story to be found somewhere regardless of the economy) but rather about the belief the central bank stimulus will continue to push share prices higher. Keep in mind that the typical Federal Reserve rate cut cycle amounts to cuts of on average 525 basis points. Today the Fed has only about half of that with which to work with before heading into negative rate territory.

The stimulus coming from most of the world’s major and many of the minor central banks likely will push the major averages higher until something shocks the market and it realizes, there really are no new clothes. What exactly that shock will be — possibly the upcoming debt ceiling debates, trade wars or intensifying geological tensions — is impossible to know with certainty today, but something that cannot go on forever, won’t.

Weekly Issue: Looking Around the Bend of the Current Rebound Rally

Weekly Issue: Looking Around the Bend of the Current Rebound Rally

 

Stock futures are surging this morning in a move that has all the major domestic stock market indices pointing up between 1.5% for the S&P 500 to 2.2% for the Nasdaq Composite Index. This surge follows the G20 Summit meeting of President Trump and Chinese President Xi Jinping news that the US and China will hold off on additional tariffs on each other’s goods at the start of 2019 with trade talks to continue. What this means is for a period of time as the two countries look to hammer out a trade deal during the March quarter, the US will leave existing tariffs of 10% on more than $200 million worth of Chinese products in place rather than increase them to 25%.  If after 90 days the two countries are unable to reach an agreement, the tariff rate will be raised to 25% percent.

In my view, what we are seeing this morning is in our view similar to what we saw last week when Fed Chair Powell served up some dovish comments regarding the speed of interest rate hikes over the coming year – a sigh of relief in the stock market as expected drags on the economy may not be the headwinds previously expected. On the trade front, it’s that tariffs won’t escalate at the end of 2018 and at least for now it means one less negative revision to 2019 EPS expectations. In recent weeks, we’ve started to see the market price in the slowing economy and potential tariff hikes as 2019 EPS expectations for the S&P 500 slipped over the last two months from 10%+ EPS growth in 2019 to “just” 8.7% year over year. That’s down considerably from the now expected EPS growth of 21.6% this year vs. 2017, but we have to remember the benefit of tax reform will fade as it anniversaries. I expect this to ignite a question of what the appropriate market multiple should be for the 2019 rate of EPS growth as investors look past trade and the Fed in the coming weeks. More on that as it develops.

For now, I’ll take the positive performance these two events will have on the Thematic Leaders and the Select List; however, it should not be lost on us that issues remain. These include the slowing global economy that is allowing the Fed more breathing room in the pace of interest rate hikes as well as pending Brexit issues and the ongoing Italy-EU drama. New findings from Lending Tree (TREE) point to consumer debt hitting $4 trillion by the end of 2018, $1 trillion higher than less five years ago and at interest rates that are higher than five years ago. Talk about a confirming data point for our Middle-class Squeeze investing theme. And while oil prices have collapsed, offering a respite at the gas pump, we are seeing more signs of wage inflation that along with other input and freight costs will put a crimp in margins in the coming quarters. In other words, headwinds to the economy and corporate earnings persist.

On the US-China trade front, the new timeline equates to three months to negotiate a number of issues that have proved difficult in the past. These include forced technology transfer by U.S. companies doing business in China; intellectual-property protection that the U.S. wants China to strengthen; nontariff barriers that impede U.S. access to Chinese markets; and cyberespionage.

So, while the market gaps up today in its second sigh of relief in as many weeks, I’ll continue to be prudent with the portfolio and deploying capital in the near-term.  At the end of the day, what we need to see on the trade front is results – that better deal President Trump keeps talking about – rather than promises and platitudes. Until then, the existing tariffs will remain, and we run the risk of their eventual escalation if promises and platitudes do not progress into results.

 

The Stock Market Last Week

Last week we closed the books on November, and as we did that the stock market received a life preserver from Federal Reserve Chair Powell, which rescued them from turning in a largely across-the-board negative performance for the month. Powell’s comments eased the market’s concern over the pace of rate hikes in 2019 and the subsequent Fed November FOMC meeting minutes served to reaffirm that. As we shared Thursday, we see recent economic data, which has painted a picture of a slowing domestic as well as global economy, giving the Fed ample room to slow its pace of rate hikes. 

While expectations still call for a rate increase later this month, for 2019 the consensus is now looking for one to two hikes compared to the prior expectation of up to four. As we watch the velocity of the economy, we’ll also continue to watch the inflation front carefully given recent declines in the PCE Price Index on a year-over-year basis vs. wage growth and other areas that are ripe for inflation.

Despite Powell’s late-month “rescue,” quarter to date, the stock market is still well in the red no matter which major market index one chooses to look at. And as much as we like the action of the past week, the decline this quarter has erased much of the 2018 year-to-date gains. 

 

Holiday Shopping 2018 embraces the Digital Lifestyle

Also last week, we had the conclusion of the official kickoff to the 2018 holiday shopping season that spanned Thanksgiving to Cyber Monday, and in some cases “extended Tuesday.” The short version is consumers did open their wallets over those several days, but as expected, there was a pronounced shift to online and mobile shopping this year, while bricks-and-mortar traffic continued to suffer. 

According to ShopperTrak, shopper visits were down 1% for the two-day period compared to last year, with a 1.7% decline in traffic on Black Friday and versus 2017. Another firm, RetailNext, found traffic to U.S. stores fell between 5% and 9% during Thanksgiving and Black Friday compared with the same days last year. For the Thanksgiving to Sunday 2018 period, RetailNext’s traffic tally fell 6.6% year over year. 

Where were shoppers? Sitting at home or elsewhere as they shopped on their computers, tablets and increasingly their mobile devices. According to the National Retail Federation, 41.4 million people shopped only online from Thanksgiving Day to Cyber Monday. That’s 6.4 million more than the 34.7 million who shopped exclusively in stores. Thanksgiving 2018 was also the first day in 2018 to see $1 billion in sales from smartphones, according to Adobe, with shoppers spending 8% more online on Thursday compared with a year ago. Per Adobe, Black Friday online sales hit $6.22 billion, an increase of 23.7% from 2017, of which roughly 33% were made on smartphones, up from 29% in 2017.

The most popular day to shop online was Cyber Monday, cited by 67.4 million shoppers, followed by Black Friday with 65.2 million shoppers. On Cyber Monday alone, mobile transactions surged more than 55%, helping make the day the single largest online shopping day of all time in the United States at $7.9 billion, up 19% year over year. It also smashed the smartphone shopping record set on Thanksgiving as sales coming from smartphones hit $2 billion.

As Lenore Hawkins, Tematica’s Chief Macro Strategist, and I discussed on last week’s Cocktail Investing podcast, the holiday shopping happenings were very confirming for our Digital Lifestyle investing theme. It was also served to deliver positive data points for several positions on the Select List and the Thematic Leader that is Amazon (AMZN). These include United Parcel Service (UPS), which I have long viewed as a “second derivative” play on the shift to digital shopping, but also Costco Wholesale (COST) and Alphabet/Google (GOOGL). Let’s remember that while we love McCormick & Co. (MKC) for “season’s eatings” the same can be said for Costco given its food offering, both fresh and packaged, as well as its beer and wine selection. For Google, as more consumers shop online it means utilizing its search features that also drive its core advertising business.

As we inch toward the Christmas holiday, I expect more data points to emerge as well as more deals from brick & mortar retailers in a bid to capture what consumer spending they can. The risk I see for those is profitless sales given rising labor and freight costs but also the investments in digital commerce they have made to fend off Amazon. Sales are great, but it has to translate into profits, which are the mother’s milk of EPS, and that as we know is one of the core drivers to stock prices.

 

Marriott hack reminds of cyber spending needs

Also last week, we learned of one of the larger cyber attacks in recent history as Marriott (MAR) shared that up to 500 million guests saw their personal information ranging from passport numbers, travel details and payment card data hacked at its Starwood business. As I wrote in the Thematic Signal in which I discussed this attack, it is the latest reminder in the need for companies to continually beef up their cybersecurity, and this is a profound tailwind for our Safety & Security investing theme as well as the  ETFMG Prime Cyber Security ETF (HACK) shares that are on the Select List.

 

The Week Ahead

Today, we enter the final month of 2018, and given the performance of the stock market so far in the December quarter it could very well be a photo finish to determine how the market finishes for the year. Helping determine that will not only be the outcome of the weekend’s G-20 summit, but the start of November economic data that begins with today’s ISM Manufacturing Index and the IHS Markit PMI data, and ends the week with the monthly Employment Report. Inside those two reports, we here at Tematica be assessing the speed of the economy in terms of order growth and job creation, as well as inflation in the form of wage growth. These data points and the others to be had in the coming weeks will help firm up current quarter consensus GDP expectations of 2.6%, per The Wall Street Journal’s Economic Forecasting Survey that is based on more than 60 economists, vs. 3.5% in the September quarter.

Ahead of Wednesday’s testimony by Federal Reserve Chair Powell on “The Economic Outlook” before Congress’s Joint Economic Committee, we’ll have several Fed heads making the rounds and giving speeches. Odds are they will reinforce the comments made by Powell and the November Fed FOMC meeting minutes that we talked about above. During Powell’s testimony, we can expect investors to parse his words in order to have a clear sense as to what the Fed’s view is on the speed of the economy, inflation and the need to adjust monetary policy, in terms of both the speed of future rate hikes and unwinding its balance sheet. Based on what we learn, Powell’s comments could either lead the market higher or douse this week’s sharp move higher in the stock market with cold water.

On the earnings front this week, we have no Thematic Leaders or Select List companies reporting but I’ll be monitoring results from Toll Brothers (TOL), American Eagle (AEO), Lululemon Athletica (LULU), Broadcom (AVGO) and Kroger (KR), among others. Toll Brothers should help us understand the demand for higher-end homes, something to watch relating to our Living the Life investing theme, while American Eagle and lululemon’s comments will no doubt offer some insight to the holiday shopping season. With Broadcom, we’ll be looking at its demand outlook to get a better handle on smartphone demand as well as the timing of 5G infrastructure deployments that are part of our Disruptive Innovators investing theme. Finally, with Kroger, it’s all about our Clean Living investing theme and to what degree Kroger is capturing that tailwind.

 

Brexit from London

On June 25th, while in London, I had the pleasure of joining David Asman on Fox News to discuss the meaning of Thursday’s vote to leave the European Union. The view of Brexit from London has been stunning. All those who underestimated the British sense of self-confidence and desire for sovereignty or who were over-confident in the betting odds giving only a 25% change of leaving, are now paying dearly for that confidence. The shock amongst most in the financial sector in London is palatable, with the lights burning bright in most offices all weekend, as portfolio managers, investment bankers and traders work to get their arms around just what this means for them and their clients.

What this means for the US

Pundits in the US are trying to calm markets buy assuring them that this won’t over overly impactful for the US as the UK, the fifth largest economy in the world, only accounts for roughly 3.8% of world GDP, according to estimates for 2016 from the International Monetary Fund, versus the United States, which accounts for around 25.4%. But that misses that this is not just about the UK, but rather about the future viability and success of the European Union, whose GDP is nearly the same as the US. With the tumultuous and highly contentious presidential election cycle in the US,  about 50% of the world’s economy is now experiencing a high level of political uncertainty within the context of an already weak global economy. That is a strong headwind to growth for everyone.

The most immediate impact of Brexit for the US likely a continued increase in the strength of the dollar, which is great for American tourists abroad, but a challenge for American multinational firms that export their products and/or services. The strong dollar will also impact emerging markets that have a good deal of debt denominated in U.S. dollars, acting as a headwind to those economies as that debt becomes more expensive. The uncertainty of how this all will pan out means transactions and contracts between companies in the European Union and with companies outside of the union may be put on hold or cancelled entirely – more headwinds to growth.

Many today are harshly criticizing the Brexit leadership for not having a clear plan for what to do if their side actually won, but the reality is that kind of a plan was literally impossible. A plan would have required having some clarity on how agreements would be worked out with, primarily, other European nations. The leadership of the rest of the European Union had every reason to assure the UK that, “Fine, you want to leave us! Then we will refuse to play with you anymore!” as they desperately wanted the UK to stay. But now that the decision has been made, and after time soothes the many bruised egos a bit, real conversations can begin.

Impact on European Union

The bigger issue here is that the European Union has not delivered on its promises to all who joined. Many countries are suffering in ways that were not expected, with internal tensions rising with every passing year of weak economic growth, high unemployment (particular among the youth) and supercilious finger-wagging from the stronger nations at the weaker ones. As hope for a recovery fades, desperation is rising and the belief that those in Brussels are a cure is shifting to suspicion that they are instead the disease. One of the greatest lessons of political history from the dawn of nations is that the further the decision-makers sit from those affected by the decisions, the poorer the quality of the decision. History shows that the more people that are forced into one size-fits-all solutions, the poorer the end result, often times with dramatic actions to break those bonds.

Those countries in the European Union that have been struggling to reignite their economies post-financial crisis will be closely watching as the events unfold for the UK, placing a lot of pressure on everyone involved. European leaders find themselves in a catch 22. On the one hand, they will be better off having strong trade relationships with the UK, but on the other hand they don’t want other nations that may be contemplating their own exit to see the UK benefiting from this move. Expect more threats, grandstanding and predictions of doom and gloom before this breakup drops from the headlines around the world.

Italy's Recent Election and Europe's Ongoing Struggles

On June 22nd I had the great pleasure of speaking with Ameera David on RT’s Boom Bust about Italy’s recent elections and Europe’s ongoing struggles, just on day before the United Kingdom holds a referendum on remaining within the European Union.

Rome has just elected its first woman mayor in nearly 3,000  years, the 37-year-old Virginia Raggi, who is a member of the Five Star Movement which was started by comedian Beppe Grillo. This election was highly representative of the challenges facing much of the western world. The campaign promises of those now in office have been forgotten and in their stead we get more of the same disappointing lackluster growth. Infrastructure from trains in Italy to roads in San Diego are in an embarrassing state, looking more and more like what one would expect to see in third world countries. Ms. Raggi campaigned on a platform of anger at frustration with the status quo, a sentiment that appeals to many across both the US and Europe, but her time in office is likely to be a big disappointment as Rome is a massive and incredibly complex city to manage and her background gives no confidence that she’ll be able to manage such an enormous challenge. I hope I’m wrong.

In the US, we have an unprecedented presidential election dynamic wherein the two presumptive candidates enjoy less support from within their own parties than has ever before occurred in modern history. In Europe faith in Brussels’ ability to help get economies within the union growing at a more tolerable rate are fading as is faith in the benefits of the European Union itself. The two largest economies on earth are experiencing heightened level of political turmoil that is likely to continue for some time, as the problems are structural and deep in nature, exacerbated by the aging demographics and under increasing pressure from the immigration/humanitarian crisis.

Things are going to get a lot more complicated before they get better. The asset price “put” assumed to exist through the omniscience and omnipotent of central bankers is becoming more tenuous. There are more and more potential major catalysts for a downturn out there, which means investors need to be prepared to manage heighten downside risks in a market that is already priced with a head-scratching level of optimism.

[youtube https://youtu.be/dZztNgVHZYI?t=6m50s&end1530]

Brexit

Brexit

Brexit. It’s all the rage these days. The word is whispered over candlelight glasses of wine in dark corners at swanky post-market-closeBrexit, Symbol of the Referendum UK vs EU cocktail bars. It is spit out over conference room tables amongst such phrases as “contingency planning” and “hedging strategies.” It has everything a news agency drools over, drama with the dark horse effect as the yes vote gains unexpected traction on the very last loop around the track.  It provides angry rants that skirt around xenophobia or at least a level of indignant nationalism that can generate eye-catching headlines. It paints the image of a battle of wills between the confident and worldly intellectual, gazing with vague annoyance over wire-rimmed glasses at the rough and tumble, calloused working man who is damn tired of those immigrants stealing jobs. It is a story filled with fear, hope, anger, frustration, isolation and unity.  Whatever version of the story attracts you the most, as an investor a “yes” vote for the UK to leave the European Union has two major impacts, currency and uncertainty.

Currency Effect

The currency effect means a stronger US dollar relative to the Euro and Pound Sterling. This would make american exports more expensive and imports relatively less expensive. The United States is the second largest exporter in the world, so when our exports become more expensive, that’s harder on everyone buying our stuff so it becomes a headwind to growth. With imports relatively less expensive, Americans are more likely to purchase an imported product than they otherwise would have been, which can also hurt american producers.

The currency effect can also be a problem for emerging markets where companies have issued unprecedented levels of debt denominated in US dollars. As the US dollar rises in value, that debt become more and more expensive, resulting in everything from reduced investment in growth to defaults which are further headwinds to global growth.

The currency effect can also have a secondary impact in its correlation with oil. With oil denominated primarily in dollars in the global marketplace, strengthening dollar means weaker oil prices. This can then affect the sovereign wealth funds from those oil-dependent nations as they are pressured to sell assets in order to pour more back into their domestic economies. This is a headwind to global asset prices.

Overall the currency effect is essentially deflationary for the US, which makes it more difficult for the Federal Reserve to return us to a more normal rate environment, prolonging the negative side effects from low-to-zero interest rates.

Uncertainty Effect

The uncertainty effect is all about the impact on companies. Although the word sounds easy enough, Brexit, short, simple and comfortably straightforward, the reality is no one really knows just how this darn thing will pan out! If there is in fact a yes vote, unthinkable a few weeks ago but now looking increasingly like it just might happen, no one is clear as to just how it would be implemented. Then there is the reality that the vast majority of politicians in the U.K., regardless of party, are all against a Brexit, so these folks will find themselves having to enact legislation based on a vote by their constituency that goes against what they believe is best; rock meet hard place.

With the realities of the actual implementation unknown, companies will be much less likely to invest which means less spending/less growth. There will be less M&A activity and the potential momentum of this vote with respect to rising nationalism is a further headwind to already falling levels of global trade which means even slower growth across the globe.

Brexit, the end of french kisses along the Thames?