June 2016 Markets Commentary

June 2016 Markets Commentary

What an extraordinary month! The unexpected happened when the United Kingdom voted to leave the European Union. That was followed by an almost unprecedented political collapse inside both the UK Conservative and Labour parties. The UK may break up as there is now uncertainty over the future of Scotland and Northern Ireland within Great Britain. Across Europe, anti-EU parties are gaining support and further referendums are now more likely. And yet, at the time of writing, global equity markets have broadly regained any lost ground and some are even up on their pre-Brexit levels. Common wisdom was that the fall out from Brexit would be severe. So why hasn’t that happened?

The short explanation is interest rates. Interest rates globally are at historical lows with an unprecedented 20% of sovereign (government issued) bonds trading at negative interest rates. Against this backdrop global investors are finding it very hard to sell equities as there simply isn’t anywhere else to put their money. 

The Governor of the Bank of England, Mark Carney, has just signalled that the British central bank will cut interest rates to support the economy and any rate rises from the US Federal Reserve are now likely to be on hold until next year.  

Apart from the short-term economic impact, the vote to leave the European Union is fascinating from an historical perspective as it reflects the first significant pushback in recent times by a nation against the globalisation trend.

The graphic below shows the surge in support in Europe for anti-EU parties, particularly on the right wing, and this increase in popularity is likely to grow following the UK referendum and perceived ongoing immigration issues. A number of the critical European countries, including Germany and France, have general elections next year and the future of the EU is most likely to be the major issue.

What has happened?

The United Kingdom had a referendum on the 23^rd of June and the question was asked:  “Should the United Kingdom remain a member of the European Union or leave the European Union?” The Leave campaign won the vote 51.9% to 48.1%. Voter turnout was 71.8% with more than 30 million people voting making it the highest turnout in a UK-wide election since the 1992 general election. Interestingly, England voted strongly for Brexit at 53.4% as did Wales. Scotland and Northern Ireland both backed “remain.”

While the referendum was non-binding, and there are valid criticisms around making constitutional changes based on a simple majority populist vote, it seems widely accepted in the UK that an exit will now occur. David Cameron, the British Prime Minister and leader of the Conservatives has resigned and the Leader of the Labour Party is under pressure to follow.

What has the financial markets reaction been?

Initially markets were caught off guard having priced in a low probability of Brexit, despite polls suggesting it was too close to call. Unsurprisingly, risk assets (including shares, oil and commodities) were sold off heavily, particularly those in Europe. Safe haven assets rallied, with gold hitting two-year highs and bond prices rising strongly. Currencies saw extreme volatility as votes were counted, with the Pound being the biggest loser, falling to its lowest level since 1985 against the US dollar. However, since then equity markets have rallied strongly and are now back to or above pre-Brexit levels.

What happens next?

In order to leave the EU, the UK has to invoke Article 50 of the Lisbon Treaty. This article has never been tested so no one really knows how it would work in practice but essentially, once Article 50 is invoked, the UK has two years to negotiate its withdrawal. We now have the unusual position where those championing the leave campaign have indicated that they want to take a long time to manage the exit process and those who wanted the UK to remain now want it out as soon as possible. Given there is now a political vacuum in the UK it is likely that it will be a while before any process is announced. In the interim nothing much changes and all laws and trade arrangements continue to apply.

Why is Brexit seen as such a big deal?

The UK exiting in itself is not a catastrophic event. Remember that the UK is not part of the Euro currency and has its own Central Bank. Europe also has much to lose if it tries to take a hardline on trade with the UK – the UK actually imports more from Europe than it exports.

The big concern is that this has happened at a time when Europe is very vulnerable economically and the UK move may embolden other European nations to exit. The Euro currency experiment is struggling and if any major nation pulls out it could lead to a collapse of the Euro and subsequent significant damage in financial markets.

Why did the UK electorate vote to Leave?

There are many reasons for this including concerns over loss of sovereignty, a push back against uncontrolled immigration (as seen in the graph below), anti-globalisation views, protest voting or even anti-establishment sentiments. Global leaders in the western world have a serious problem on their hands in that the benefits of globalisation have not been felt by middle income workers – for instance in the US and UK, real wages have been stagnant for decades. The benefits of globalisation are often seen to have accrued to a few super wealthy and to the political elite.

What are we doing at Devon in terms of your Fund?

Our Funds have limited direct exposure to the UK or Europe other than from weaker equity markets.  The NZ companies with the greatest economic exposure are Air NZ (6% of their revenue is earned from the UK), Orion Health (14%), Skellerup (15%) and Xero (16%) - we have no exposure to these businesses.   

In Australia our major exposure is through our holding in Australian listed stock Westfield, which has significant shopping centre assets in the UK.  Whilst FX translation is a negative, this has been partially offset by the falling Australian dollar. Lower consumer confidence/spending and the ability to lease new projects will be the main issues in our view.  

Due to elevated levels in equity markets we had been positioning our Funds more conservatively over recent months. The Alpha Fund, which is able to hold significant levels of cash when shares are expensive, was at 40% cash on Friday.

We will be watching market developments closely because volatility often provides opportunities to buy high quality stocks at attractive prices.

 Paul Glass - Principal at Devon