Something’s got to give!
By Rome Mostert, CFA
We’ve had a week and a half (both literally and metaphorically) of trading since the #Brexit referendum. Since then we’ve seen asset classes move with great vigor in all directions and ultimately end up surprising most market participants as to their ultimate direction:
- Equities – Over all stocks have been fairly neutral, with major US indices tracking back to their pre Brexit levels. The bulls stood firm in London with the FTSE 100 more than retracing its initial slide and now trading the highest it’s been in nine months, and from a technical perspective, it seems set to go higher. However, the FTSE performance in Sterling is no big surprise given that approximately 70% of the earnings of the index are not GBP based, so the index offers exceptional hedging qualities on the exchange rate. In Europe it’s been a different ball game, with both the DAX and CAC still respecting the most recent downward trends while lower lows and lower highs continue to shape the current theme. Performance across EM has been mixed, however the dollar laggards of 2015, like Brazil and South Africa, have stood steadfast among international peers.
- Treasuries – US bonds have rallied aggressively since Brexit day with the yield curve (10yr minus 2yr) continuing to flatten as the 10yr yield is coming off at a rate much faster than that of the 2yr. The US yield curve is currently at 80bps and appears to be moving towards becoming more flat, or possibly, inverted. A particular surprise, however, is the strength in both equities and bonds at the same time, but more about that later. In Europe yields have continued to slide with negative yields through 50yrs in Switzerland, 15yrs in Japan and Germany, 8yrs in France, 6yrs in Ireland and 3yrs in Italy and Spain. In the UK yields initially spiked as rating agencies downgraded Britain, however has since more than retraced and continued its downward path and is now the lowest since the financial crises (take that S&P, Moody’s and Fitch!) The positive UK 10 yr yield (at 0.84%) in light of a 9% weaker pound (versus Euro) is starting to look fairly attractive from European perspective despite the ratings tantrum! With the ECB continuing to crowd the Eurozone debt market, GBP debt might be an interesting punt for European fund managers. The US 10yr yield, however, continues to offer real tangible value (compared to the UK and European yields) at a yield of 1.45%.
- Currencies – The direction of the pound has been singular, weakening against virtually every global currency over the past 10 days. The dollar versus the Euro, no major direction change has taken place with the dollar still within its 18-month long consolidation after a long bull trend. EM currencies have mostly strengthened after hitting oversold levels late 2015 following home-grown issues, FED rate hikes and a related selloff.
- Commodities – Let’s first think dollar, as is always the case when talking commodities. For a few years now the FED has prepared the market on the inevitable hiking cycle that is coming. In December 2015 we saw the first 25bps hike and at the time a number of increases were expected for 2016. Since we’ve seen the FRA curve flip a 180, with the probability of a FED cut in 2016 at 10%, now larger than that of a hike at 0%. In fact, a lot of the asset allocation that we’ve seen over the last week and a half (increased correlations, rising equities and bonds) suggests that the market is pricing in a probability of QE4, or more global monetary easing of a different sort, or from a different country. With a weaker dollar back on the table, as opposed to previous projections of a stronger dollar on the back of a rising Federal Funds Rate, commodities prices are set to rise. In fact, with commodities completely overshooting to the downside while fear took control of the asset class, significant upside seems warranted. Especially in high beta juniors.
- Volatility – Volatility has been extreme over the past week and a half. On Brexit day (Friday the 24th of June) the VIX spiked 49.3%, recording the 5th largest single day percentage point increase ever. The following week the VIX decreased 40%, making it the largest weekly percentage point decrease ever, which includes a 21.4% decrease on Tuesday the 28th of June, the 9th largest daily decline ever.
So what is the smart money telling us?
With the latest increases in equities, treasuries and gold, more questions are being raised than answers given.
Firstly, in the buildup to Brexit investors took the conservative rout and stockpiled vast cash positions, as per BofA Merrill Lynch Fund Manager Survey suggesting cash levels of 5.7% pre-Brexit, the highest since Nov 2001. This coupled with the current “buy the dip” mentality has led to yet another V shape recovery, the umpteenth time since the 2009 start of the current bull market. So basically investors were sitting on record levels of cash that needed to be deployed post Brexit, or stood the risk of being on the wrong side of the tracking error.
Secondly, the last week’s market action suggests that there is still no maturity date set on the FED put. Despite the FOMC still guiding for higher interest rates, the market seems to be already banking on more QE, be it from the FED or BoE or #moar from Draghi or BOJ.
Thirdly, over the past 27 months we’ve witnessed the S&P (1840 – 2130) and JSE Alsi (41800 – 49000) trading in wide sideways ranges, with a number of sharp V-shape recoveries in between, as the BUY-THE-DIP strategy paid off time and time again. Equity markets have been moving sideways despite weak economic growth and slumps in earnings, which has seen valuations rise despite lackluster market performance over the past year.
Fourthly, from a technical perspective there is little blatant bullish conviction unless the market convincingly breaks through the multiyear resistance ahead.
To conclude, in the near term (next two months) as long as the US yield curve remains upward sloping (which is currently the case), we believe that the ongoing search for yield in a “risk on” environment will drive continuous fund flow towards equities and high yielding emerging market debt, continuing to stimulate the “BUY-THE-DIP” mentality.
In the medium to longer term, however we foresee that ongoing Brexit uncertainties, potential other referendums (FREXIT = FRANCE, GREXIT = GREECE, NEXIT = NETHERLANS, SWEXIT = SWEDEN, DEXIT = DENMARK, HEXIT = HUNGURY) and global economic growth concerns could further drive treasury yields lower and ultimately invert the US yield curve. Should the US yield curve invert, we will be extremely cautious of global equities that are sitting on historically rich valuation multiples, especially if this lines up with the upcoming August to October period, which includes the seasonally weak September futures close out, which has historically been a good spot to short into.
Our recommendation for now would be to hold on to cyclical high beta equities and emerging market debt, but look to sell in the near term as they head into resistance. Longer term we prefer defensive equities and valuation as a style which includes attractively priced resource stocks and perhaps the listed British property stocks. On the fixed income side, we will be continuing to hold long duration (which we’ve been holding ever since Nenegate), looking to switch to short duration around the R186 pivot range of 8.0% to 8.5%.