The Market’s Brexit Dip

The pound and global equity markets continued selling off on Monday, while debt markets rallied (prices up, yields down.)  Despite the Fitch and S&P downgrade of the UK’s credit rating (S&P went from AAA to AA, matching France), UK ten-year yields fell sharply to a new low of 0.93 percent. That’s between the 1.44 percent yield for the U.S. (in dollars) and 0.29 percent for France (in euros.) 

There’s lots of talk of Brexit being a Black Swan event causing a run on the UK, a China devaluation, or margin calls against hedge funds.  Most of the market movements so far, however, have been a reversal from excessive moves.  Versus the euro, the pound is back at 1.20 euros per pound.  That’s its early-2014 level prior to the ECB’s devaluation of the euro (in late 2014-early 2015, see graph), yet airline stocks cratered on Monday on fears of reduced British ticket sales. 

China’s yuan weakened to 6.65 per dollar, putting it back to its 2011 level. The yuan had strengthened in 2011-2014 to help China enter the IMF’s SDR basket.   We expect China to use its currency to send signals.  It’s worried about the global slowdown, miffed that its equities weren’t added to the MSCI index, and angry that the U.S. is increasing its military presence in the South China sea.  Brexit and the pound’s big devaluation provide an opening for China to let the yuan slide weaker. 

Many global equity markets tumbled Friday and Monday, but are well within the boundaries of the gains made since March. The DAX, FTSE, and Russell 2000 rebounded in February-May even as global growth slowed.  Even apart from Brexit, those equity gains were suspect given the weakness in corporate profits, the rollover in equities since 2014 (see graph) and the shrinkage in world dollar GDP since 2014 (see Lack of Economic Growth vs. Unrealistic Earnings on May 2).  

Most bond yields fell on Monday, giving no indication of systemic risk.  High-yield debt is normally sensitive to financial stress -- the Baa to AAA spread has been narrowing, not widening.  Credit markets are showing less stress than in 2015 when oil price declines were pressuring oil-related debt and threatening contagion.

The massive leveraged bond buying by the ECB and BOJ (and the Fed through its reinvestment program) is pushing many bond yields down. We think that’s an increasingly dangerous mistake by the central banks. It has created a severe shortage of duration in the private sector, flattening the yield curve and hurting insurance companies and banks, which were hit hard again on Monday.  The central bank policies cripple growth, but create a kick-the-can convergence trade -- sovereign bond issuers are too-big-to-fail and are providing credit umbrellas for increasing amounts of global debt (see Now Is the Time to Raise Interest Rates 6/9/14 WSJ).  Italy’s ten-year bond yield has been below that of the U.S. despite EU obstacles to Italy setting up a bank resolution/bailout process (though there were signs of progress on it on Monday as Italy takes advantage of Brexit to push Brussels toward its position.) 

Spreads on European periphery debt widened some after the Brexit vote, but are still within the range set in mid-February. The widening is mostly due to falling German yields (the benchmark).   Portugal needs to maintain at least one investment grade rating so the ECB can keep buying its debt.  That rating is now being provided by DBRS, a Canadian firm. 

The surprise Brexit outcome is, for now, a stress test of equity valuations, particularly bank stocks and life insurance companies.  They have to price in the prospect of very low interest rates and slow growth for the foreseeable future.  We think there would have to be more signs of a global recession to trigger a bear market.  The catchy headline on Monday was that the market’s $2 trillion loss on Friday was the worst ever.  However, it followed many stellar weeks and months of even bigger equity gains, including the S&P 500 back near its all-time high.

We think the market’s challenges are bigger than Brexit and longer-term in nature: slow global growth, high asset prices relative to earnings, no exit path from harmful Fed/ECB/BOJ policies and negative interest rates, declining import/export volumes, disinflation and over-capacity, and lack of structural reforms (tax, regulatory, labor flexibility) in the U.S., Japan and Europe. 

Prior to the Brexit dip (S&P 500 down 5.7 percent so far), we’ve tracked eight equity dips and stress tests since mid-2013, each focused on a particular market concern.  The largest was the 13.9 percent peak-to-trough S&P 500 dip in January 2016 related to high yield, U.S. growth and incorrect market rumors of a large China devaluation.  We don’t think Brexit is as big a risk for global growth outlook as those problems, but it will take time access the growth impact (and the extent of the equity dip.)   

A key variable is Europe’s reaction to Brexit and the EU’s ability to improve economic policies. Looking beyond Brexit, however, we remain deeply concerned that negative interest rates are drawing the world into deflation, with no sign that central banks have any contingency plan (other than to redouble their current policies, making matters worse.)  

David Malpass is president of Encima Global LLC.

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