The investment markets have seen a lot of turbulence in the last 24 hours. If there ever was an event that established the
futility of crystal ball prognostication, it was Brexit. The polls, the betting markets, the leading financial pundits and the
world markets themselves all suggested that the UK would vote to remain in the EU, yet it did not. We’ve been speaking
for some time about the sluggish nominal growth and the highly levered global environment that have led to less predictable
geopolitical forces and more political populism. And these forces really asserted themselves in the past 24 hours.
We would describe what we saw today as more of a surprised environment than a truly distressed one. Market risk
perception is certainly up, but it is not extreme. The VIX index of implied volatility has risen to slightly over 20%. This
is a little above average but well below the 40%+ implied volatility that we see in real market crises. The S&P 500 Index
was down 3.6% today, but it is still within 5% of its all-time high. The Barclay’s High Yield Index was soft, but it edged
down less than 2%. And while gold was strong, it’s still well below its highs of a few years ago.
It will take some time for us to get a clear read on the long-term impact of Brexit. David Cameron, the UK prime
minister, has resigned, but we won’t know his successor for some time. In fact, it’s likely to be a few months before his
successor is appointed. Candidates for his position are quite different in character, and the choice the Conservative Party
makes will no doubt have a bearing on the UK’s negotiating posture as it withdraws from the EU. This process is likely
to take a couple of years. The key area of focus here will be the UK’s access to the single EU market, as this represents
nearly half of UK exports. The EU heads of state are not meeting until next Tuesday, so we won’t have a preliminary read
on their intent until then.
We simply don’t know if the UK will negotiate a position close to what it already has, along the lines of Norway, for
example, which maintains full access to the single market in exchange for labor mobility, fiscal transfers, and willingness
to accept most EU legislative directives. It’s also uncertain whether Germany and France will want to make the divorce
painful enough to dissuade other EU members from considering this path forward. In the short-term, this uncertainty
is likely to weigh heavily on the UK’s economic performance. Longer-term, the combination of a weak currency and
perhaps a more flexible legal and regulatory regime could be a positive for the supply-side of the UK economy, but we’ll
simply have to wait to see how policies unfold.
The UK itself is small in a global context, so the question of contagion is actually more important. On this score, we will
be closely monitoring developments in the European banking sector, credit spreads for high yield issuers in Europe, and
spreads for the peripheral sovereign issuers. There are also political developments that we’ll have to keep an eye on. There
are elections this weekend in Spain, an Italian constitutional referendum in October, and then we’ll be looking at what
the polling trends are for euro-skeptic politicians like Le Pen in France. Then there are French and German elections
scheduled for next year. There’s also the potential for renewed talk of a Scottish referendum on independence.
There are many paths that both markets and the political economy can go down, given the propensity of central banks
to rush to the rescue whenever a danger seems to lurk. Central banks have already stated their willingness to provide
liquidity if required. Futures markets now predict that a rate hike in the US is all but off the table this year. Having said
that, the ammunition that central banks of the world have is somewhat more limited today, unless they choose to engage
in increasingly unconventional policy, which could actually add to expectational uncertainty at some point.
Property and construction companies in Europe weakened, and export-oriented Japanese companies were
hurt by the dramatic appreciation of the yen. Some of the most pronounced weakness in markets was in sectors we’ve
avoided, like the European banks. We’ve seen no reason to rush in there, despite the statistical cheapness of such securities.
In the US, stocks that are economically sensitive declined, but we saw these as temporary rather than permanent
impairments of capital. A number of the more defensive names in the portfolio held up relatively well in the market
turmoil. Our potential hedge in gold has also served us well. Gold has rallied sharply in the last 24 hours, and, generally,
gold-mining shares have, as well. We made no dramatic shifts in our asset allocation but selectively took advantage of the
market dislocation to add modestly to some positions.
Our foreign exchange hedges were largely unchanged. The euro and pound weakened, but we believed the undervaluation
was modest enough to warrant no changes. In the UK, we maintained our hedges on companies that operate in the
domestic market, but we have not hedged our positions in UK-based multinationals, which have generally weathered the
storm relatively well.
The crystal ball remains foggy at best, not just for us, but for all market pundits. The complex global backdrop makes
specificity in forecasting even more difficult than usual.
Just my opinion, of course.
