Britain votes to leave the EU, now what. Markets naturally went to risk off with the Pound taking the majority of the hit. We now know that the out come is but there is no clarity on how things will play out going forward. The Brexit gamble is over and money was made or lost, now investors need to look at the bigger picture to see what, if anything, has changed.
Near term, the world will be on high alert. Risk off trades and shifts to US and Yen denominated plays. Also on alert will be the Central banks. One sided bets on currencies could see intervention back on the table. It would be a good excuse for the Bank of Japan to undertake direct market intervention in the markets. The bank of England could try to stabilize the pound if the slide continues next week. The rally in the dollar could even pressure China to take measures to weaken their currency, in this environment the markets would not turn an eye to potential issues across the globe.
Longer term, things will be more measured. The formal exit from the EU is a two year process and more clarity will come through as time progresses. Trade deals and contracts will not cease to exist in immediately. That being said look ahead there will be changes to the way Britain is looked at in terms of investment and banking. Shares of major banks in the UK are already down about a 3rd on the news, which could be an over-reaction or discounting of the future prospects of the city of London outside the EU.
It is important to take this information and compile it into the global story and not let it simply shape it. The lead up to the Brexit vote kept other global factors on the back burner and the out vote will no doubt take precedence in the near term. This should not take attention from the fact that other global factors are occurring and could be the the next 'black swan' event to hit the markets. Not because it was a rare unpredictable event, but rather no one was looking.
The Bank of Japan left rates unchanged and did nothing to address the rise in the currency over the past weeks. This led to the natural rally in the Yen to the 104 range against the dollar. While the governor of the BOJ did say he would not hesitate to take additional steps towards easing, the lack of action in combination with flight to safety conditions from the Brexit kept the currency near lows not seen for almost 2 years in dollar terms.
There is more to the overall assessment of Japan at this time. As discussed in earlier posts the demographic shifts are working against the Japanese economy and the threat of the country losing its safe haven status is slowly increasing with inaction. Fitch warning of a credit downgrade with the delay of the tax hikes will cause international investors to look at these negative yielding securities with a lower credit rating as un-investable. This will leave the BOJ on the hook to continue to be the sole buyer of JGBs and it will be difficult to find buyers at the right yields to replace them.
Commodities have experienced a good run in the past rally. Oil now above $51 a barrel and gold up about 15% of looking at the GLD. Many macro factors can pay into this trend with China and other markets not having the day of reckoning that seemed so likely even through May. These factors helped commodities off their lows (along side some external shocks in the oil sector) but the dollar cannot be ruled out as a main driver of performance. Fundamentals in oil have not changed in the near term, with OPEC not coming to any agreements at the past meeting. Gold is taking the majority of its cues from the dollar movements this year, with the volatility of the Fed rate hiking decisions providing the majority of those moves.
I still believe that the market is underestimating yields and the poor jobs numbers reinforced that bias. As a result I think that the call for gold to continue its accent from this point could be met with some resistance and will need another catalyst to continue higher. More market turmoil could be a cause of this, if there seems to be a spillover into the real economy and the Fed decides to hold off on rate increases over the summer.
After the shock in jobs numbers on Friday all eyes will be on Yellen today at 12:30 est. as she will provide more clues to the Fed assessment of the recent drop in jobs numbers. What she says will be particularly insightful into the way the Fed will treat the data over the coming months regardless of whether there is a rate hike in July or not.
Should the Fed stick to their prior comments that one data point doesn’t signify a trend, it will mark the Fed as more committed to the longer term trend in low unemployment and rising wages being a precursor to inflation. By getting ahead of the trend they will be able to keep the inflation rate from getting out of hand while normalizing the interest rate curve. This will allow for cyclical rate increases/decreases to start to take shape.
The other side of the equation is that the Fed has been looking for an excuse, which would fit within its mandate, to not raise rates. This would make the case that the Fed is concerned about global growth and the spillover effects it may have on the US economy. If this happens I would assume that the Fed will seek to delay any real rise in rates until later in the year and look for inflation to hit the 2% target, or even over, before feeling confident in starting a normal rate hiking cycle.
Looking at the current trend in oil it seems that a move back to the lows of the year are a lot less likely. Having moved up 80% from the lows a lot of the oil industry players have seen higher share prices and tightening spreads in the bond markets. While still bullish on the longer term prospects of oil, it could be a good time to take some profits from the more aggressive oil plays in a portfolio or hedge to some degree.
The OPEC meeting today is going to show some clues to what the group is thinking but there is little action that is expected. The positions of the countries seem to be entrenched with Saudi Arabia and Iran in a market share dispute and some of the smaller countries like Venezuela and Nigeria in turmoil from lower prices. What is more concerning is the fact that temporary supply disruptions in Canada, Nigeria, and slowing production in Iraq have caused the supply and demand situation to balance out, albeit temporarily. Once these changes to the supply side dissipate you could see some resistance to the upward moves in oil prices. From a stock perspective, anything dividend paying should be held onto because the elevated price will help to ensure a steady payment cycle (perhaps some covered calls would be a good choice for them). Any outright plays in the move in oil prices has most likely seen a good run and should have profits taken while looking for a better entry point in the future.
Abe has delayed the tax hike until 2019 and this has caused the Nikkei to go down over 1.5% yesterday. Today in Japan it seems to be more of the same (this time because of the stronger Yen according to news sources). The new of the delay in the tax hikes was not what most economists were looking for and the markets are in agreement. As stated earlier the delay in the tax hikes is going to be a slow erosion of confidence in the government’s ability to manage the longer term budget. In the meantime the measures taken to stimulate growth could speed up this process as the Government spends more and increases the deficit.
Source: Yahoo Finance
The Central bank is now a major player in the bond market, owning around 37% of the market. As demographics works against the country the BOJ will have to take over the purchasing of bonds from the retirees that become spenders as opposed to savers. This fine balance must be maintained due to the face that there are higher yielding alternatives to make JGBs less attractive to outside investors.
Source: Japan Macro Advisors
The issue with the lack of growth and more stimulus being added to the economy could be a greater budget deficit that will make it harder for the BOJ to absorb the bonds left by the slowing domestic demand and the growing needs to bonds, forcing the bank to increase stimulus alongside budget needs. This would take the monetization of debt a step further to monetization of the budget gap, and potentially turning the Yen and JGBs into the least safe haven.