“I trust you but cut the cards.” –W.C. Fields
So the Brexit vote eventuated in a “leave” vote. As of this writing, the world has not come to an end and markets, which traded down on the news (plus the sort of amusing anecdote that “what is the EU?” was the most frequent Google search in the UK post vote), have more than recovered. The economic uncertainty about what future trading relationship the UK will have with the EU should delay UK spending decisions and thus depress growth there, with radiating, but smaller impact on neighboring economies. Here are some of our thoughts on Brexit and other markets opportunity shaping considerations:
Brexit Fallout is just one of Several Headwinds to US Equity Returns Near-Term. Other risks include the upcoming US Presidential election, unstable growth and policy in China, and a deceleration in corporate buybacks, which represent the largest source of demand for US equities. However, despite Brexit we expect decent US GDP growth of approximately 2% in the second half of 2016. Aside from negative risk sentiment, potential UK weakness should have a minor fundamental impact on the S&P 500 because Europe in aggregate contributes less than 10% of total S&P 500 revenues.1
The Fallacy of Economic Contagion, the New Risks of Political Contagion. Beyond this simple economic uncertainty effect, to get a much larger impact on global asset prices, we would need to see financial or political contagion. Financial contagion is mostly a function of leverage and the impact on banks; which is in our mind is simply not large enough. The imposition of fund gates on some UK REITs is putting investors on alert, but any downside on UK and London real estate ought to be offset by upside on the Continent. Hence, there’s a low likelihood of this problem spreading outside the UK. European bank stocks are down badly, as the weaker economy and displacement costs of potentially having to move part of the City to the Continent would raise costs. However, Italian Banks are in excellent position to extract help (they took none back in 2008, and it suggests the value of staying in the EU).
Political contagion is of greater concern, in particular if the UK exit worsens centrifugal forces in the EU. Anti-EU populist parties are clearly emboldened by the UK vote – but they are tiny and almost toothless (despite what TV pundits say). In addition, as the reality rather than the dream of exiting the EU sets in for the UK, its appeal for copycat action in the EU should fade. The UK psyche and cultural temperament is unlike the rest of the EU (call to discuss).
More broadly, should we interpret Brexit as a worrying sign of the rise of populism and nationalism in the world and the twilight of globalization? At the margin, the shift is clearly there, but it is not pre-ordained it will continue. Low growth in incomes and jobs, however, does raise voter dissatisfaction, which could lead to populist actions. A rapid move into anti-globalization and antitrade policies and politics would sharply and ultimately raise macro volatility and uncertainty. Younger voters generally have been supportive of globalization. In addition, several South American countries, where populism had reigned for many years and voters had seen it brought no comfort or advantage, chose this year to re-enter the pro-market fold. A rise in protectionism is possible in the world, but it is equally possible that governments seize the initiative and instead try to boost growth through fiscal expansion.
The Global Profits Stall. Since 2010, profit growth has stagnated, a major shift from the past two expansions when profits grew at a double-digit average annualized pace.
Profit Weakness is Broadly Based. Neither the Developed Markets (“DM”) nor Emerging Markets (“EM”) have seen profits grow on average over the past five years. This compares to a boom in the 2000’s. DM profits stagnated even after the Euro area recovery took hold in 2013. EM weakness extends beyond Brazil’s deep contraction and commodity producing countries.
DM Revenues Have Stagnated. A slowing in revenue growth, closely related to the downshift in nominal GDP gains, has been an important source of the global profit stall. However, regional performance has varied. Much of the falloff in DM revenue growth represents sharp declines recorded over 2011-12 as the Euro area and Japan contracted. A clear message is the damage recessions inflict on revenues. In contrast to the DM, EM revenues have moderated in this expansion but to a still-solid 6% annualized pace of growth.
We are Likely Done with a Secular Rise in Margins. Although revenue trends hew closely to the growth cycle, profit margin dynamics are more complex. They move up and down with nominal growth but also display patterns driven by secular forces. From the 1990’s through 2007 a general upward trend in global profitability can be observed in which margins steadily expanded, with only temporary disruptions when growth weakened. Margins are now moving in reverse. Corporate profitability has never recovered its pre-recession levels during this expansion, and by the end of 2015, global margins stood at just 7.8%, 2.2- pts point lower than their earlier cyclical peak at the end of 2007.2
1 Diminishing Returns: Why Investors May Need to Lower Their Expectations, McKinsey & Co, May, 2016.
2 Profit Stall Threatens Global Expansion, JP Morgan Economic Research, June 21, 2016.
The above post has been excerpted from a letter of Tiburon Capital Management.
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