Q2 2016 review
BREXIT, China, Gold and more
As I am writing this review I fear that by the time you read it, it will be very much out of date, such is the pace of flow of information following the Brexit “surprise”. At this stage, it definitely seems more like political turmoil than real economic turmoil. If there is one thing I have learnt over my 17 years in the wealth management industry it is that when the market is scariest and when the newspapers are using the most sensationalist fearful headlines - that is the time to buy not sell.
Position vs. View vs. Risk Management
I wrote in the Q1 review that Brexit was coming and the vote was too close to call. We knew that if it were going to be an Exit vote victory, markets would not be happy. If it were going to be a Stay vote victory, markets would see this as a long-term endorsement of the EU and European assets could have risen significantly. We therefore spent a lot of time discussing this issue and analyzing its potential impact using internal and external experts. After detailed consideration (not always unanimous across the professional team), we took a view that it would be a Stay vote victory, however we did not position the portfolio’s in any way. We had analyzed our risk and exposure should it be an Exit result and we were satisfied that the portfolios were sufficiently robust to protect us from the initial shock. Up until the time of writing, this analysis has proved to be correct and markets seem to be turning positive to make back some of the initial losses. What many people do not realize is that as the vote approached, markets gained significantly as they expected a Stay vote and we saw significant gains during June. Therefore, when the actual turmoil started on Friday, the month to date numbers were not too bad at all. Even with a significant event like Brexit right in front of you, we firmly believe that one cannot time the market.
Within a few hours of the result, David Cameron had resigned in a political maneuver designed to dump the responsibility for negotiating the UK’s way out of the EU quagmire onto the new incoming Conservative leadership. This was a shrewd political move. However, the result is that we may have a non-Brexit as it is doubtful that there will be enough political will to implement the decision and to dive on the proverbial grenade. A pro Exit leader would have their hands full dealing with the EU problems without enough political support, and if it is Theresa May, who was against an Exit vote all along, it is unlikely that she will "pull" the ominous Article 50 trigger. The mechanics of the exit start with giving notice under this article and then there is a time line of two years to negotiate the consequences. The EU is under political pressure because the other economically strong countries may also start to make exit overtures signaling the ultimate end of the EU (many years away but could happen one day). The critical country here, in our opinion, is the Netherlands. In addition, the strongest EU partner, Germany, values its trade relationship with the UK and does not want to jeopardize it so a non-Brexit political solution may be found. The list of political forces goes on and on and on, making the prediction of the outcome entirely impossible, therefore we are just going to have to live with the uncertainty. Guessing now the long-term implications is actually impossible and we will have to be fluid and flexible in addition to watching our European and UK allocations. Bottom line: the markets will be even more sensitive and volatile.
Regardless of how one feels about the Exit vote victory, we should not lose sight of Europe’s fundamental weaknesses. Separate fiscal powers with a single currency were always going to cause problems and according to the most basic economic principles, is unsustainable. However much monetary policy easing the European Central Bank tries to use to create growth, e.g. Government Bond buying, Corporate Bond buying (together sometime referred to as "printing money"), negative interest rates; it cannot overcome the mountains of bureaucracy that small businesses within the EU have to comply with. These small businesses are vital for the growth that is required. A fundamental principle of the EU is free movement of labor. Labor moves to where the opportunities are, leaving the weaker EU countries, even weaker. These weaker EU countries still have to maintain sound fiscal positions to support their share of the EURO currency. To further complicate things these weaker countries are politically unable to create the structural reforms required to become strong. You can see that there is a cycle taking place, which arguably is causing the EU to be a pyramid scheme, which will one day come crashing down. UK voters have chosen to face those consequences and leave now before they go down with the ship.
Perceived Risk vs. Real Risk
In my dealings with High Net worth families, a lesson worth sharing has emerged. The perceived risk is often market and investment based. However, a well run and diverse portfolio would be able to at least match risk expectations reasonably well. Therefore, there should not be any surprises there for the family. The real risks are the risks that most families pay less attention to, e.g. inter-family relationships and the complexities of global taxation. Taxation mistakes can be very expensive, resulting in unnecessary double taxation and expensive death taxes (even if the investors are not a resident of that country). Again, taxation risks can be managed with proper advice and reasonable expectations. When inter-family relationships go sour, the cost in time, money and mental energy can be enormous. This is seldom spoken about and rarely addressed. In our position as wealth managers, we are exposed to all types of family relationships and we see from the inside when there are issues. A trusted advisor is often essential in the communication process with the potential heirs to help them understand the complexity of the family wealth and set realistic expectations. Managing these risks is not just about the year to date performance. Its about who, from inside or outside the family, will deal with the complexity after the key person has passed on and how will the heirs even begin to deal with this complexity the day after. Pioneer Wealth Management is prepared to actively engage in helping clients address this critically important issue.
I have written about Gold several times in the past. It has done well in 2016 and therefore I have faced many questions about it lately. The basic investment case for gold is very weak and the only possible reason for it is that it sometimes adds protection when there is a crisis or inflation on the horizon. There is no inflation on the horizon, especially in the Eurozone, however it does appear that Gold is currently offering some protection from the market volatility. We are unlikely to add it to our model portfolio’s, but on a case by case basis certain clients may be willing to take on some of the differently volatility offered by this ancient asset class.
Don’t forget China
Whilst our attention is focused on the UK and EU relationship, we must not forget what caused an even bigger market sell off than Brexit and that was the commodity collapse at the end of 2015, which led to the China “hard landing” fears of January 2016. The losses in January were even bigger than the losses of the last week of June 2016. China will be back to scare us. There is too much debt behind China’s exceptional growth. Interestingly, the default process there is different to the West. In the West, the first losers are the equity owners, then the junior debt, then the senior debt, then the bank loans. In China, it is all subject to negotiation and political influence. The state owns and controls all the big banks, so if there is enough political will the government will tell the bank to extend the debt. Apparently, they really fear revolts by employees and small investors. This is why we believe it is a state controlled economy. The problem is that the Chinese authorities cannot rescue every company every time and therefore this debt bubble will burst over time in little fits and starts, which will scare the global market. There is a lot to be concerned about in China. However, we do not believe that China will collapse in a massive debt bubble. There is too much state control backed by about 3 trillion USD to protect their currency.
Market Performance in Q2 2016
Simply put, down in January and February, up a lot in April, May and most of June, then down a lot. This volatility is a result of essentially two things: a low interest rate environment and the macro stories described above. Here are some more interesting numbers to illustrate this volatility.
|Asset Class|| |
|EuroStoxx 50 (SX5E)||-17.97||11.2.16||-7.65||-9.41|
|Russel 2000 (RTY)||-16.04||11.2.16||-1.53||2.21|
|HY Bonds (H0A0)||-5.14||11.2.16||3.25||9.32|
|Investment Grade Bonds (ITR)||0||1.1.16||2.98||5.55|
|Brazil (EWZ US)||-13.85||11.2.16||-1.38||2.15|
Outlook for rest of 2016
Until clarity emerges on Brexit, there is significant uncertainty and one simply cannot predict the future. Uncertainty can drive markets both up and down very suddenly. In addition to the Brexit uncertainty, we still have the problem of exceptionally low interest rates and this means people will continue their search for yield taking more and more risks, so we believe this provides some tailwinds to drive markets up. Our big fear is European banks, which are the buffer between Brexit fear and short-term systemic risk in Europe. There is still enough protection there; however, we are watching that space closely. Previously we have said that the USD 10 year Treasury bond rate would fluctuate between 1.7% and 2%, however it seems that Brexit has reset that in a lower range of 1.4% to 1.8%.
Israel at a glance
While it is difficult to see the short-term positives about the possibility of a British exit from Europe, at least from Israel’s point of view there are some possible political benefits. From an economic point of view, the Brexit effect on Israel is minimal compared to Israel’s other challenges of fighting for legitimacy. Israel exporters to British companies may be affected with the large swing in currency making these goods 10% more expensive.
The local stock market continues its negative trend finishing the quarter down 3.17% (TA 100). Most of this loss can be attributed to the overseas volatility and uncertainty. The local bond market, especially longer-term government bonds, benefited along with US treasuries from the uncertainty. This gain is temporary and will put pressure on future yields. We still see opportunity in sectors less affected by Brexit like communications, local property, and consumer stables. Especially good dividend companies.
The aforementioned information is not a substitute for personal Investment marketing, which takes into account the particular circumstances and special needs of each person. The views expressed in this Review should be considered as market comment for the short term for information purposes only. As such the views herein may be subject to frequent change, are indicative only and no reliance should be placed thereon. This Review does not constitute legal, tax or accounting advice, or any investment recommendation, or any offer to buy or sell financial instruments of any kind, and does not take into account the investment objectives or needs of specific investors. Although this Review has been produced with all reasonable care, based on sources believed to be reliable, reflecting opinions at the time of its writing and subject to change at any time without prior notice, neither Pioneer Wealth Management nor any other entity or segment within the Pioneer International Group makes any representations or warranties as to the accuracy or completeness hereof and accepts no liability for any loss or damage which may arise from its use. The writer and the company are unaware of any conflict of interest at the time of publishing the above commentary.