The Coming EXITentialist Crisis

British voters decided to leave the European Union on June 23, potentially ending 43 years of membership. At BCA Research, our investment philosophy is that, at critical junctures such as this one, it makes sense to take a cold shower and resist making any rushed investment decisions. Brexit, if it were to go ahead as currently planned, has the potential to change the world. But how that will impact investors is a question that will take time to answer.

There are, however, some broad conclusions that we can begin to draw from the U.K. referendum. The most obvious is that the decision to leave the bloc strikes at the stability of the European Union, which is one of the core post-World War Two institutions that have kept peace in the Western world for the past seventy years. As such, its implications – if London actually follows through on the referendum – will be profound.

The U.K. referendum will also have implications for the global distribution of power. The world lacks global leadership as the U.S. wanes in relative geopolitical power. From an investor’s perspective, this is a negative trend, since “multipolarity” is both empirically and theoretically proven to be a harbinger of inter-state conflict. In recent years multipolarity has largely been mitigated by the persistence of Cold War-era institutions that allow the U.S. to amplify its power. The EU, NATO, and financial institutions such as the IMF and the World Bank are such entities.

By leaving the EU, the U.K. does not necessarily undermine this global order, but it does show that a 43 year-old geopolitical relationship can end. It will weaken the EU as a global player, given the U.K.’s formidable “hard” power, and aid Europe’s geopolitical rivals. And if it leads to the disintegration of the EU — which is not our base case at BCA Research despite the conventional wisdom — it will massively increase global geopolitical risk. I suspect that my clients in the financial industry will have to brush up on obscure geographical references – such as Alsace-Lorraine, Silesia, and South Tyrol – by the time this process is over, if it ever begins.

This would be a profoundly negative outcome. It is not an exaggeration to say that generations that thought they would never see another armed conflict on the European Peninsula could be in for a surprise.

On the domestic political front, the rise of anti-establishment movements – particularly in the U.S. and U.K. – has been one of the most talked-about themes in the financial community in 2016. However, it is unclear how to price any risk of non-centrists coming to power. Investors have had widespread disbelief that populism could win any major vote in any major economy. I can attest to this personally, as it has been difficult in recent months to get many of my friends and clients in London City to take Brexit seriously. I have received more questions about Austrian, Portuguese, and Spanish elections in the first quarter of 2016 than about the upcoming U.K. referendum.

I suspect that the focus over the next several months – in terms of assigning risk premia – will remain on Europe. However, the reality is that middle class malaise may be the most advanced in the laissez-faire economies of the U.S. and the U.K., especially now that the “debt supercycle” (a major BCA Research theme for the past 30 years) is no longer available to assuage the pain of decade-long stagnant wages.

In a way, anti-globalization policies are merely the right-of-center approach to redistributing income. It is now clear that the last three decades of free trade and laissez-faire policies have led to growing income inequality as winners of globalization captured most of the gains and losers were left to face the consequences, and the painful adjustment, without much redistribution. Take the vote on EU membership, which saw all of England vote to leave except for the financial capital of the world, London.

For Bernie Sanders and Jeremy Corbyn – as well as Podemos in Spain and SYRIZA in Greece – the answer is to dial up the redistribution. For Donald Trump, UKIP, and Marine Le Pen in France, the answer is to wall off their economies and hope to stave off redistribution by shifting the blame for tepid growth to the outside world. Both policies will be equally bad for equity markets and risk assets, as they will erode profit margins one way or another.

The 1990s consensus on deregulation, privatization, low taxes, budgetary discipline, and free trade is over. The median voter is shifting away from laissez-faire and demanding economic policies that contravene the 1990s “Third Way” consensus (Diagram 1). According to the median voter theory, policymakers will shift with the median voter to a new center and will not shift back to the old center once they capture power.

DIAGRAM 1 – So Long “Third Way” Politics!
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This is bad news for emerging markets, in particular. It is also bad news for the shares of global companies who have benefited tremendously from the steady dismantling of barriers to the free flow of goods, capital, and labor.

In the long run, the decline of globalization will also usher in higher inflation. As my team and I wrote in 2014, globalization has effectively produced the largest supply-side shock in the history of mankind. As such, it is a major deflationary force. But if policymakers respond to populism with protectionism and fiscal expenditure, then the deflationary forces of globalization will reverse. Perhaps sooner than the market expects.

Read full Special Report

 

[1] Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization – All Downhill From Here,” dated November 12, 2014, available at gps.bcaresearch.com.

 

China: Has Policy Reflation Lost Momentum?

After exhibiting improvement since late last year, the most recent Chinese economic data have deteriorated on the margin. This is largely due to changes in policy stance. Policies implemented late last year induced a quick growth acceleration, which are now prompting the authorities to switch back to focusing on “supply-side” reforms.

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The Chinese authorities are struggling to perform a difficult balancing act. Through their reflationary policies, they are trying to push overall growth close to potential. However, at the same time, policymakers want to avoid “lifting all boats”.

Case in point is the steelmakers. Widely viewed as a sector with a hopeless excess capacity problem that urgently needs to be consolidated, steelmakers have witnessed a sudden bounce in profitability since late last year when Chinese reflation began to gain momentum. The authorities are concerned that policy reflation will simply prolong the lives of these supposed “zombie” firms, and the tough decision to cut their lifelines will still need to be made in the coming years once the current round of policy reflation runs its course. Worse still, if these sectors continue to expand capacity with the latest policy help, it will further worsen the situation when the day of reckoning finally arrives.

In other words, as “cutting overcapacity” is one of the key objectives of Xi Jinping’s “supply side reforms”, aggressive cyclical policy reflation appears to be in conflict with this longer-term consideration. In this vein, it may be comforting for the “supply-siders” that the sudden rebound in steelmakers and some other sectors such as construction materials and earth-digging machines have quickly rolled over. This should at least ease concerns over bailing out “zombie” companies.

Looking forward, our China strategists continue to argue against any policy tightening and major growth disappointment, but investors should also curb their enthusiasm in assessing China’s demand-side countercyclical initiatives.

U.S. Equities: Margin Optimism Is Not Justified

U.S. corporate profit margins are already narrowing, but bottom up forecasts are looking for an aggressive move out to new highs in the coming quarters.

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Given U.S. labor cost inflation, revenues need to snapback from their current contraction to achieve even modest margin expansion. The growth backdrop is not conducive to such a development. The yield curve, which is an excellent business cycle indicator and a leading signal for profit margins, continues to flatten relentlessly.

Fewer than 50% of the non-financial and non-utility industry groups are currently expanding profit margins. Yet 8 out of 10 sectors are expected to grow margins according to analyst earnings estimates.

Specifically, cyclical sectors such as industrials, materials, energy and technology are slated to show broad-based improvement in profitability. That would not be farfetched if the world were on the cusp of a V-shaped, post-recession type of acceleration and the U.S. dollar were set to weaken significantly, i.e. more than 10%. After all, cyclical sector profit margins are very depressed.

However, deleveraging and the global credit contraction warn that global growth is not about to rebound. As such, our U.S. equity strategists remain skeptical that the macro backdrop will validate upbeat analyst forecasts, rendering the broad market vulnerable.

Brexit: The Final Days

Our European Investment Strategy service recently published a report entitled “Brexit: The Final Days, Part 1”, which includes discussions that 30% of voters will either make up or change their minds in the last week before the U.K.’s crucial referendum on EU membership, half of them on the final day itself. Ahead of Britain’s most important vote in a generation’, this two-part report discusses what investors should focus on in the last few days, and how to position before and immediately after the vote.

To access the report entitled “Brexit: The Final Days, Part 1”, please click here.

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Shadow Fed Funds Rate Says Sell U.S. Equities

Investor optimism has been rekindled as weakening U.S. employment has deferred Fed interest rate hike expectations. Nevertheless, the Fed may stay hawkish because the labor market is near full employment, unemployment insurance claims remain below 300K, core inflation is firming and wage inflation is trending higher. Monetary conditions have been tightening ever since the Fed completed its bond purchases in October 2014. Using the Wu-Xia shadow Fed funds rate, it is obvious that a less accommodative Fed at the margin has let the volatility genie out of the bottle and, more importantly, capped equity market returns. Thus, the risk remains that the Fed raises rates and rekindles the loop of a higher U.S. dollar leading to tighter global financial conditions, in turn causing a stock market correction, and forcing the Fed to back off its hawkish rhetoric.

Bottom Line: While a run toward all-time highs is possible leading up to the next Fed hike, the risk/reward tradeoff remains to the downside and our Global Alpha Sector Strategy service cautions investors not to chase equities higher from currently extended valuation levels.

For additional information, please visit our Global Alpha Sector Strategy website at gss.bcaresearch.com.

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