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.

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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.

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Policy Uncertainty And Global Equities

Rising global policy uncertainty should lead to lower equity multiples.

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There is no doubt that policy uncertainty in Europe has risen since last week’s U.K. referendum. The Global Policy Uncertainty Index, created by Baker, Bloom and Davis, is almost certainly much higher today than its last datapoint in May 2016 shown in the chart above.

The uncertainty originating from the U.K.’s “leave” vote will only reinforce weaker global growth and likely trigger a de-rating in global equities. Over the past 12 months the U.S. equity market has repeatedly failed to break above its May 2015 highs. Such market action could be a sign of major top. Meanwhile, global ex-U.S. share prices have been in a bear market for about a year and seem to be breaking down anew.

Bottom Line: Risks to global share prices are building. Investors should stay defensive.

Timely Reminders Of Sterling’s Bearish Fundamentals

The surprise Brexit vote last week dealt a severe blow to sterling. Beyond the vote, the fundamentals remain negative for the British pound. Timely reminders came today from the BoE governor and the Q1 current account release.

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Even before the Brexit outcome, the risks to the U.K. economy were tilted to the downside. Heavy fiscal drag was in the pipeline and the housing market, particularly in London, was cooling. The OECD’s LEI for the U.K. has been heading down since mid-2014, well before the referendum was called. The referendum outcome will only exacerbate the economic slowdown. As U.K. businesses face significant uncertainty ahead, investment spending and hiring will surely suffer. The Bank of England will be forced to ease monetary policy, pushing interest rates closer to zero and/or restarting QE. Earlier today, BoE Governor Carney signaled that more accommodation could be coming this summer.

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Aside from economic weakness and the potential for monetary easing, there is another key negative for sterling: the huge current account deficit. Today’s data showed that the external deficit hit a new modern day record of nearly 6% of GDP in the year to 2016 Q1. This is larger than the deficits seen prior to the 1992 ERM crisis and ahead of the 2008 global financial crisis. The increased political and economic uncertainty following the Brexit vote will make it much more difficult for the U.K. to finance such a large current account deficit smoothly.

Bottom Line: On a short-term basis, sterling is oversold and some technical consolidation/retracement is possible. However, the medium-term fundamental outlook remains bearish. Sterling is likely to make new cyclical lows versus the dollar, euro and yen over the next 3-6 months.

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.

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[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.