Brexit Update: Does Brexit Really Mean Brexit?

The U.K. has a new Prime Minister – former Home Secretary Theresa May – who has committed her cabinet to pursue a divorce from the EU. With the government in London now falling inline with the mantra that “Brexit means Brexit,” is there no hope for a reversal of the June 23 referendum results?

In this Brexit Update, we tackle three questions:

  1. What is the big picture relevance of Brexit?
  2. Have the “next steps” of the Brexit saga become any clearer?
  3. What does the U.K. want and can it get it from the EU?

The global relevance of Brexit is that it will signal to the markets that stimulative fiscal policy is around the corner. To be clear, Brexit will not cause fiscal stimulus (at least not outside the U.K.).

To access the Geopolitical Strategy Special Report report entitled “Brexit Update: Does Brexit Really Mean Brexit?”, please click here.


Global Equities: No EPS Pulse

Brexit aside, what matters most for global equities is earnings growth, especially if the multiple expansion phase since 2012 is over.

The chart shows that the global PMI, industrial production and credit impulse are still signaling a challenging EPS growth outlook. This message is corroborated by the bond market. Anemic growth prospects, deflation/disinflation and deleveraging have pushed global bond yields to all-time lows. Under such a backdrop, a capital preservation mindset is still warranted. Continue to prefer global defensives to both early and late cyclicals.

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Will Brexit Put The Bond Bull Out To Pasture?

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.

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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.

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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 profitability of tradable goods producers globally.

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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 U.S. 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.

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U.S. 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 U.S. is pretty constructive.

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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.

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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.

To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s July 13th Webcast.

U.S. Equities: Few Signs Of A Sales Or Profit Rebound

Policy uncertainty will remain elevated, putting upward pressure on risk premiums. The upside of uncertainty is that monetary and perhaps even fiscal policy will be looser than otherwise would be the case. That is a plus for stocks, but may cushion downside risks more so than propel capital appreciation in the absence of stronger global growth.


Deficient global aggregate final demand remains the defining characteristic of the global economy, given high debt loads and ongoing private sector deleveraging in the developed world. The developing world may need to undergo a similar fate. Policy is already extremely easy, but has been unable to spur much growth. Global trade remains very weak.

U.S. companies are already having difficulty generating sales growth. Inflation expectations have plunged, and are an excellent leading indicator for actual corporate sector pricing power.

Any additional U.S. dollar strength would amount to a tightening in global financial conditions, importing deflationary pressures into the U.S. and dampening top-line prospects.

In turn, that would prolong the retrenchment period required to right-size the cost structure of many businesses, especially in the face of the recent increase in labor costs. It is no wonder our profit model cannot gain any traction.

As a result, the Brexit vote does not alter our portfolio strategy, if anything, it reinforces it. Defensive sectors had been outperforming prior to the referendum in response to an increasingly shaky global economic outlook.

BREXIT – Next Steps

Investors trying to make sense of the post-Brexit political environment should adopt a simple maxim: the only certainty is uncertainty. No amount of poring over EU Treaties, U.K. legislative acts, or ancient Celtic runes will bring clarity on whether the country will ultimately leave the EU. Our view is that Brexit is a political act. As such, the process can certainly be constrained by economic reality or law, but it can only be fully reversed through another political act.

In this update on the “next steps,” we focus on the key inflection points at which U.K. policymakers may be offered the opportunity to reverse the decision made by the referendum. The diagram below suggests that there are several. However, many are overstating the ability of “technicalities” to change the outcome of the referendum.

To access the latest Geopolitical Strategy Special Report report entitled “BREXIT – Next Steps”, please click here.