We discover today that what was initially reported as an armed robbery was actually a misunderstood negotiation. No, I'm not referring to the story of the four US Olympic swimmers in Brazil: I'm talking about Brexit. Many feared that global markets would feel the shock of the British vote in favor of leaving the EU, but – apart from the impact on the pound – the post-referendum collapse lasted only a few days, as the Bank's reassuring reaction of England (BoE) and solid data in other regions allowed investors to focus on global growth.
Right now, the three major US stock indexes are nearing record highs, emerging market equities are at 12-month highs, high yield bonds have held up despite oil volatility and, at the other end of the spectrum of risk, the demand for government bonds of developed countries is so high that 40% of these bonds are now recording negative yields. Our diversified portfolios and overweight position in US equities benefited from the post-referendum rally. Over our six-month tactical investment horizon, we believe the markets still retain some upside potential. We are overweight US investment grade equities and bonds versus high grade issues and emerging market equities versus Swiss.
But is it possible to go further and outline a scenario that goes beyond the reabsorption of fears related to Brexit? What is needed for a possible positive side to emerge from the vote that has caused so much discussion? On a global scale, the UK referendum has reignited the debate on the limits of monetary policy, which could prove profitable if it results in a series of more coordinated fiscal and monetary stimulus. And in the UK itself, Brexit could represent a historic opportunity to improve the country's economic fortunes, if the right examples are followed.
In the footsteps of Switzerland?
The UK will have to choose which path to take in order to achieve the bright economic future promised by the proponents of Brexit, but there is no shortage of examples of countries that have successfully negotiated with the European Union (EU) and achieved greater economic prosperity.
According to the then Swiss economy minister, a staunch pro-European, it was a "sad day" when Swiss citizens voted against the country's entry into the European Economic Area (EEA) in 1992. Yet, the Confederation still managed to flourish from an economic point of view and since 2004 it has climbed seven positions in the global ranking of competitiveness of the World Economic Forum, until reaching the first place. Thanks to its low-cost regulatory model and emphasis on expertise, Switzerland has become a magnet attracting companies of all types, from multinationals to start-ups. It filed more patent applications per capita than any other country in the world last year and surpasses the EU in terms of workforce adaptability.
If UK political leaders are to follow suit, they will have to make tough decisions. For example, despite having chosen to remain outside the European circle, Switzerland has opened its doors to foreign workers and has thus been able to access the single market and record strong economic growth. Furthermore, in the eyes of the United Kingdom, Swiss policy may appear to be a kind of permanent austerity: according to OECD data, from 2006 to 2014 Switzerland had an average budget surplus equal to 0,5% of GDP, compared to the average deficit of the 6,5% of UK GDP. But the United Kingdom has many of the attributes needed to follow the example of the Confederation, if it wants to. The British corporate fabric, like the Swiss one, benefits from inexpensive regulation, a highly skilled workforce and a tradition of innovation. Furthermore, outside the EU, the UK will be better able to create the kind of business-friendly climate that helps explain Switzerland's success.
If UK leaders make the right decisions, the UK may succeed in realizing and exploiting the 'bright side of Brexit' for the long term.
Bright Side for the World – Today
The "brightness of Brexit" that emerged on the markets was not caused by the publication of more positive than expected economic data in the United Kingdom; it will take months for indicators to attest unequivocally how the British economy has reacted to the vote. Far more important was the magnified impact of the BoE's statements on global yields. The bank effectively ended the carry trade on Gilts by announcing a new round of quantitative easing and in doing so helped revive the global “hunt for yields”. In particular, the subsequent reduction in rates on Treasuries supported prices.
Falling yields reduce the cost of corporate debt in the US, boosting profit margins in the world's largest economy. Emerging markets are also benefiting from the lower cost of servicing debt for foreign currency issuance: recently the yields of the JP Morgan EMBI (government bonds) and CEMBI (corporate bonds) indices fell to 4,81% and 4,92% respectively .XNUMX%, the lowest levels for three years now. Furthermore, the strengthening of emerging currencies against the weaker dollar curbs inflation in countries of the region, reducing the need for their central banks to raise interest rates.
Falling global yields make it even more likely that US monetary tightening will be implemented at a very gradual pace, as the Federal Reserve (Fed) will want to prevent damaging dollar appreciation. We expect just one US rate hike this year, which won't happen until December.
In the future
The new post-referendum monetary stimulus has managed to push risky assets higher, reassuring the markets, but it has also highlighted that the quantitative easing plan is now close to its limit. BoE Governor Mark Carney specified that UK interest rates will remain in positive territory, even though 40% of developed country government bonds now offer negative yields. Markets welcomed his critical view on the effectiveness of negative rates, which in turn will put pressure on Europe and Japan in particular to go beyond rate cuts in an effort to support growth.
Chancellor of the Exchequer Philip Hammond has already signaled the end of the financial austerity espoused by his predecessor, George Osborne. The European Commission's decision not to impose sanctions on Spain and Portugal for exceeding the maximum deficit threshold implies a certain leniency on the part of the EU authorities after Brexit, perhaps due to fears for European unity. In turn, Japan, also close to the limits of monetary policy, has launched a package of public spending measures for JPY 28 trillion (USD 000 billion).
I'm not saying government spending is a panacea for low growth and productivity, but these signals suggest that the Brexit referendum could be the catalyst needed for governments to adopt more growth-friendly policies, allowing central banks to catch their breath .
The door for Brexit to deliver positive outcomes for both the UK and global markets is still open, but it won't be forever.
Tactical asset allocation
Trends in global economic growth, central bank policies and corporate earnings justified our risk appetite. US consumption remains healthy; according to the Atlanta Fed, average wages are growing at a rate of 3,4%, close to the highest levels since March 2009, and the net wealth of American households is at record levels. Growth in domestic demand in the second half of the year will boost earnings per share, which are expected to rise 3% year over year. The recovery in investment spending in the energy sector also bodes well for US manufacturing activity.
With financing costs only gradually rising, the cost of corporate debt will remain low for US and emerging market companies.
This picture plays into our overweight in US and emerging equities in global portfolios. US equities still remain attractive relative to high grade bonds, even though they trade at a 15% premium to past average price-earnings since 1960. In credit markets, we remain overweight US investment grade bonds, which with a by 109 basis points (bps) still offer an attractive yield premium over high grade bonds.
We also maintain an overweight position in emerging market equities relative to Swiss equities. Encouraging signs of stabilization have emerged in emerging economies, where purchasing managers' indexes point to strengthening activity in emerging Asia and Latin America. In turn, earnings appear to be firmer, after the 30% drop accumulated since the beginning of 2012. Conversely, the Swiss market, which has a high exposure to defensive sectors, will participate to a lesser extent in the global economic recovery.
