Almost three weeks on from Britain’s vote to leave the EU, markets have treated this political event as a negative local growth shock but a positive global interest rate shock. The upshot has been a surge in risk assets presumed less vulnerable to the growth drag, but benefiting from the ubiquitous plunge in bond yields. A spike in economic uncertainty, derived from the political uncertainty that the Brexit vote unleashed, drove government bond yields to new lows, as investors sought the safe harbor of high quality government bonds as a hedge against weaker global growth. The critical question is whether or not political uncertainty will actually translate into economic deterioration.
European bank share performance dictates the pace of bank lending. Undercapitalization and weak credit demand are particularly acute in Italy where 360 bln euros’ worth, or 18% of bank assets, are deemed to be non-performing. If Spain’s ultimate write-down of 40 cents on the euro in the aftermath of its housing bust is any guide, Italian bank’s tangible common equity coverage of gross non-performing loans needs to be 40% to weather a similar storm. New pan-European directives on bank loss resolution require shareholders and junior creditors to absorb some losses before any public recapitalization. Italian households now hold 200bln euros’ worth of bank bonds eligible to be ‘bailed in’, accounting for about 5% of households’ financial assets. For Prime Minister Matteo Renzi, local loss-absorbing bank stakeholders are also voters who, in October, will undertake a referendum on Renzi’s leadership. Failure to secure a mandate for constitutional reform will open the door for the Eurosceptic anti-establishment Five Star Movement to revive existential risks around the viability of the common currency.
With the world focused on European political risk, China’s currency is quietly drifting lower; so far this year it is down 3% vs the dollar and 7% in trade-weighted terms. The RMB is a more important anchor for emerging Asian currencies than the yen, since China exports much more, globally than Japan. A weaker RMB will allow Chinese producers to cut their export prices in US dollar terms forcing other Asian exporting nations to follow or lose market share. China still represents a source of deflationary pressure that undermines the profitability of tradable goods producers globally.
A slowdown in China, the world’s growth locomotive, has brought the deficiency of aggregate demand in developed economies less greased by credit growth in the post-debt Supercycle era into sharper focus. The growing gap between rich and poor was a key driver of the populist backlash that voted for Brexit. Rising income inequality is also one of the key factors propelling populist, protectionist sentiment in America. This trend has occurred across developed countries, depicted in the GINI coefficient, a measure of income inequality. This trend has led to a decline in real median income which has depressed US aggregate demand by a cumulative 3% of GDP since the late 1970’s. The implication is that enacting policies that reduce income inequality will help combat secular stagnation. Ironically, while the immediate impact of the Brexit vote was a flight to safety pushing global bond yields to new lows, the longer-term outcome is liable to be higher yields. The political and economic uncertainty that Brexit risk inflames has increased the urgency for more proactive efforts to boost stagnating lower and middle-class real incomes.
US Treasury yields are taking their current cues from policy uncertainty and the gravitational pull of negative yielding comparable quality sovereign paper. The Fed and markets will turn their attention back to the US domestic economic scene while they await evidence of the actual economic impact of Brexit risk on European growth. The plunge in Treasury yields belies ongoing progress toward full employment and the pickup in wage growth. We expect that while the pace of job growth has slowed, as is typical of a mature business cycle expansion, job gains in excess of 85-90k per month will be enough to tighten labor markets ultimately pushing inflation up to the Fed’s mandated 2% level. But markets discount almost no chance of the Fed hiking at all this year. This outlook has kept aggregate US financial conditions benign. The Fed is unlikely to ignore the fact that the current pulse of economic growth in the US is pretty constructive.
Investors have been sourcing income from high-quality dividend paying stocks, and capital gains from bonds; this is unlikely to continue. In the near term, we are not inclined to chase the post-Brexit rally because we still see a long bumpy runway of political and economic uncertainty over the coming months. We will upgrade our cyclical outlook for equities relative to bonds on an equity correction of at least 5%, in conjunction with evidence that the global earnings outlook is improving and the policy loosening that we expect comes into clearer view. The US is the most expensive of the developed markets viewed through any valuation lens. The erosion of US profit margins from higher labor costs, balance sheet constraints, and dollar strength coupled with the Fed’s underlying tightening bias favors cheaper markets such as the euro area, Japan, and even China where margins have scope to recover, and policy is likely to be more supportive.
While the path of least resistance for nominal yields is higher, the global output gap will take years to close; the path to higher nominal yields has to be lower yields for a long time. Thus, the best way to profit from more reflationary policies over the next two years is not by betting on higher nominal yields, but by buying inflation protection.