Global Overview July 13, 2016
Britain and EU
The speedy selection of a new leader for the Conservative Party in Britain and her subsequent appointment as Prime Minister has rather quickly restored calm to global financial markets. Markets across the board whether directly or indirectly affected by Brexit were brutally savaged by the British vote. Normalcy has returned as the British political system proved its ability to withstand turmoil.
However this is but Scene 1 Act 1 of a rather long play. The selection of a Brexit czar will lead to the next phase, which is the invocation of Article 50 of the European Union whereby the UK will formally request its exit. According to most knowledgeable sources, the negotiations may likely take up to two years. In the interim, Germany, France, Holland and perhaps Italy will face major elections. The political sentiment in these nations will probably swing right.
The Brexit negotiations will likely have its fits and starts. Not only will the UK be negotiating on behalf of itself, but since Scotland and Northern Ireland voted strongly to remain in the EU there is also the distinct possibility that the British will decide on their own union. Betting on uncertainty is the name of the game for financial markets, but for Europe it seems that we will be confronted with far more than the usual dosage. Simply put, not only is nationalism on the rise, but immigration, especially from the Middle East, has become a rallying cry for many political factions.
Therefore, we believe that European markets may likely be quite volatile with short phases of great optimism and euphoria truncated by other periods of pessimism and panic, altogether a very challenging phase for traders as well as investors.
Currently Japan is experiencing another brief period of optimism and a respite from a rather disappointing double-digit decline during the 1st half. Foreign investors to a large extent were saved by a double-digit appreciation of the yen against the dollar. This is of course against the explicit wishes and designs of Prime Minister Abe. One of the key elements of Abenomics is the depreciation of the Japanese currency. Now having resorted to negative interest rates which do not seem to be working, the Japanese government is contemplating a third round of stimulus. To us it appears that the Abe government and the Bank of Japan are digging a forever bigger hole. This may be different from our proverbial kicking the can down the road but we are afraid that the end result will be just about the same. Clearly, the Japanese are applying more of the same formula that under their socio-economic conditions, do not work. Furthermore, debasing its currency as one of its major strategies at this time when most major global economies are doing the same, is not only a non-starter but may also likely be exceedingly wasteful and risky since Japan is a significant importer of raw materials such as oil.
Here again we see a market that is vulnerable to negative macro forces with intermittent periods of optimism and euphoria.
At this point, we believe that China has dodged the big bullet. Hard landing is no longer in the vocabulary of most economists and forecasters. Detractors seem to have to resort to rehashing issues such as high leverage and high indebtedness to justify their bearish case. Yet there is no sign of impending doom. As a rather closed economy, the central government in Beijing has managed to keep rather tight control over China’s numerous problems. The recent fear about flight capital also seems to have abated. At the end of the day, foreign currency reserves still stand over $3.2 trillion. As new issues such as Brexit have grabbed the headlines, China seems to have faded to the back page. As an example, the recent decline of the yuan against the basket has not gathered much attention compared to what happened almost exactly a year ago. In the meantime, calm seems to have returned to the Chinese stock market as the economy stabilizes.
We are hopeful that the 2nd half of 2016 will be the opposite of the 2nd half of last year. As the economy continues to achieve firmer footing, there will be a realization that the valuation for Chinese stocks are very reasonable on a historic basis. Furthermore, there is the likelihood of additional stimulus measures from the PBOC.
As we enter the final phase of the Obama administration, we are beginning to understand the accomplishments and the unintended consequences of an extended period of QE and zero interest rates. It is true that the US and the world avoided a major catastrophe yet it seems that an anemic recovery has led to an extended period of anemic growth and that has become the New Norm. Zero cost to money is not normal. We strongly believe that Chairperson Yellen clearly understands that it is paramount for her to normalize the yield curve yet she has been prevented by various exogenous forces from doing so. Now Brexit and its accompanying uncertainties most likely will push the clock back again. Since the marketplace has had a negative view on rate hikes, we have had this bad news is good news syndrome prevailing. Now the consensus is Brexit most likely will delay the next rate hike. It will provide more breathing room for the market, at least in the near term.
The political party conventions in the next few weeks will force us to focus more closely on the coming presidential election. The final vote will most likely be decided by the pronouncements of each candidate during the debates. At this point, uncertainties still abound. So to us the main focus for the market is still a rate hike that will most likely be delayed by Brexit.