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Is BREXIT Just Noise?


  • Markets fell on Friday but they are exactly where they have been in the last weeks.
  • BREXIT is noise, investors should focus on slower global growth and fragile financial systems.
  • The market is still overvalued in historical terms but there are some opportunities.

Introduction

An avalanche of articles since last week’s BREXIT is forecasting terrible things for the world economy and financial markets especially. Most focus on the huge declines stock markets saw on Friday, but let us first take a closer look. The UK FTSE 100 index fell 3.15% to 6,138 points on Friday, but all-in-all it was a positive week as last week started with the FTSE at 6,021 points.

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Figure 1: UK FTSE 100 index in the last month. Source: Bloomberg.

Of course this is only the nominal decline. As the pound declined by 9% toward the dollar, FTSE losses for U.S. investors ended up at 13% in total on Friday.

The S&P 500 also fell 3.59% on Friday, but this was mostly due to the appreciating dollar. As the dollar appreciates, U.S. corporations see their international earnings deteriorate as more than 30% of revenues comes from abroad.

figure 2 dollar spot
Figure 2: Dollar index spot. Source: Bloomberg.

But again, the dollar is just back to where it was at the beginning of the month and the S&P 500 to where it was exactly one month ago on May 23. The point of this introduction is to make investors aware of the difference between noise and real structural significant influences.

What’s Important for an Investor and What’s Just Noise

In the BREXIT aftermath you will be bombarded with various crazy headlines like “FREXIT” (France leaving EU), but don’t let this move your focus from the important things. The important things are that the BREXIT will for sure have a negative impact on the already negative trend of slowing global economic growth. The World Bank has already revised its global growth expectation downwards from 2.9% to 2.4%. The BREXIT will further lower the amount of investments in and from the UK and consequently, Europe. This might push global growth even lower and keep growth in Europe subdued.

figure 3 real gdp growth
Figure 3: Global, Europe and advanced economies real GDP growth expectation. Source: World Bank.

Slower global economic growth and activity will have an impact on every aspect of economic life. But, as usual, central banks will do their best to keep things stable by adding more liquidity. The European Central Bank issued a press release immediately after the BREXIT vote stating that it “stands ready to provide additional liquidity, if needed, in euro and foreign currencies.”

This policy of constant liquidity adding by central banks has been working well in the last seven years but involves some risks. The major risk is that markets change their perspective on monetary policy as an important enough factor for market stability. As soon as central banks become unable to protect the markets with their added liquidity there is nothing to stop the markets from a free fall. Also, the increased liquidity provided by banks with no economic traction would spur inflation. Such a scenario could bring a rare economic situation called stagflation: high inflation and economic stagnation.

The second risk is also related to monetary policy and BREXIT. BREXIT being the cause and monetary policy being the reason. The low interest rates and high liquidity has brought high levels of debt globally and uncertainties about whether the central banks are going to be able to keep things stable without spurring too much inflation in an environment of continuous abundance of liquidity. This risk influenced most European banks to fall between 10% and 15% last Friday, but this was only the tip of the iceberg as the above mentioned reason lowered their share prices by about 50% in the last year.

figure 4 European banks an U.S.
Figure 4: European banks stock price in last two years. Source: Yahoo Finance.

UK Barclays, German Deutsche bank and Italian Intesa all fell by about 50% or more in the last year. The best performing bank in the above chart is Wells Fargo which has fallen only 20% in the last year. This weakness in the financial sector signals that the provided liquidity is still keeping the markets stable, but the decline of bank shares indicates that the markets are not as healthy as they used to be.

The most important thing of all for corporations and their stock prices are, of course, earnings. The stronger dollar will undoubtedly lower corporate earnings and make the already historically high valuations look even more overvalued.

figure 5 sandp multipl
Figure 5: S&P 500 PE ratio. Source: Multpl.

As the above figure shows, the S&P 500 PE ratio has only been higher than the current level on a few occasions. Recent historical examples of higher or similar PE ratios are the 1960s bull market that resulted in a decade long 1970s bear market, and the dot-com bubble and bust. The 2009 spike is related to the 2009 crisis that lowered earnings and not to market overvaluation.

Conclusion and What Can Be Done

In an environment with huge liquidity, high valuations and uncertain economic prospects, there are some things an investor can do. If the high liquidity ignites inflation, it is always good to be exposed to assets whose quantity is fixed. Such assets are commodities. Precious metals in particular as their value increases with economic turmoil. All other commodities should benefit if inflation is ignited and the global economy continues to grow.

An investor can look for companies with low PE ratios and stable non-cyclical revenues, like utilities, communications or consumer staples. It is not easy to find companies like that in this overvalued market but there are a few—like AT&T (NYSE: T) or Southern Company (NYSE: SO)—that look attractive with their PE ratios below 20 and dividend yields north of 4%. A PE ratio below the average does not mean that the price of those stocks will not go down in a bear market.

In any case, investors should brace for volatility ahead as negative economic repercussions keep constantly coming up. Now it is the BREXIT, not so long ago we had the Chinese slowdown crisis in August 2015, low oil prices in January 2016 and as more such things are bound to happen in the fragile, overvalued, highly liquid markets, every investor should prepare for volatility.

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