Brexit fear rages like a bear!
Written by: Benjamin Bimson CIMA® / BCJ Financial Group
Brexit won out over Bremain in the UK vote which resulted in David Cameron’s announcement that he was planning to resign as Prime Minister.
That very well may have been the bigger of the two market dominating factors all last week. It’s a game of dominoes now and it is very difficult to make financial decisions when policy makers are driving markets and not economics. I would love to tell you that everything is just going to be ok and here in the US have nothing to worry about, but I just can’t.
David Cameron’s resignation is just one thing to come out of the vote. Another is the questions as to whether or not the UK will keep the lucrative and huge Foreign Exchange (Currency exchange or FX) in London. No one knows whether it would move to Frankfurt, Paris or New York, but the big money changers on the FX are probably not going to be satisfied remaining London. Like many of the events of last week we will certainly have to wait and see what happens next, and as we all know markets hate to wait.
So where do we go now? Should we sell out of all the equities and run to treasuries? Well, there are a few things that we should be aware of here. Although it seems so much more comfortable in the moment, it could be a bad decision until we make sure that the effects are in fact breaking down the ability for the economy to grow at all. One thing that future markets are betting heavy upon is no further rate hikes in 2016. Pricing indicated nearly a 0% chance of that and only 12% chance in 2017. That is something we have to be very aware of. This is largely because with the Brexit, treasury buying was so heavy that policy makers would literally not be able to drive rates higher with a hike, which would cause the US dollar to appreciate further and hurt corporations.
I really like the following chart from Ned Davis Research that shows stocks relative to treasuries. What this is attempting to illustrate is that when the stock dividends in the S&P 500 are compared to Treasury Bill Yields, stocks tend to be a better investment than treasuries as long as it is more than 0.7 on the scale in the lower section of the chart (red). Despite PE ratios being high, which we have talked about quite a bit, stocks tend to outperform when policy keeps yields so low in treasuries. It is always a bad idea to try to beat the guys that can print money. They have more power than the investor!
If and when this relationship breaks down, we would argue that the economics would take over and policy makers wouldn’t be such a huge driving force. Unfortunately, we simply cannot fight the Fed and win.
In the midst of so many political movements, we have to be cautious not to get in the way. This doesn’t mean that if we see economics breaking down that we wouldn’t advocate moving to safety, but quick movements can get us caught in the cross-fire of political posturing that is sure to be coming.
Another way to look at the above is to see the flight to Germen Bunds (treasuries issued by the German government). This is seen in the next chart. We see the S&P 500 falling 3.6% on Friday and the German Bund appreciating nearly 11% in the same (flight to safety). It should be noted that the S&P 500 closed about 2071 the previous Friday, followed by a rally based on the hope the Brexit vote would fail.
On Thursday the S&P 500 closed at 2113, which was over 2% higher. Therefore, after the Brexit vote, the S&P 500 fell 3.6% to 2037. The one-week return was -1.69%. This is hardly a market crash. You can see where the US is relative to the German Bund in the following chart. The S&P 500 is again in negative territory for 2016 and the German Bund is again in negative interest rate yields.
We are watching quite a few metrics closely to monitor for signs that these are going to bring further pressure on the markets or if calm will follow the initial shock. It certainly will not be boring.
Remember that this is a big world. Politics can seem so big until you look outside and see there is so much more! Here is a picture from earlier this week (my trip to Lake Tahoe) of how peaceful things can be, but lurking out there are disruptions that can come in and change the picture quickly.
We will remain vigilant. We want to avoid knee-jerk reactions so a little patience is necessary. We will move quickly if we find it prudent, but only if things are proving to break down further. Until then, enjoy this picture of the Rubicon Springs.
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