The second quarter (Q2) started in a benign manner, with global equity markets looking to build off a strong March, but ended with one of the most cataclysmic political events in decades as a majority of British voters chose to leave the European Union (EU) on Friday, June 23rd 2016 (Brexit). The decision was a huge surprise, with oddsmakers and financial market traders expecting the opposite. Betting markets gave ‘Remain’ an 88 percent chance to win, but ‘Leave’ won 52 percent to 48 percent.
Financial markets started falling sharply as referendum results started trickling in and the odds of Britain leaving the EU rose. The British pound fell more than 8% against the U.S. dollar on June 24th, taking it to its lowest level since 1985. The pound resumed its slide in the week after.
Equity markets across the globe took a sharp downturn. The S&P 500 fell 5.3% across the two days following the vote, while the MSCI EAFE index (in USD terms) fell 9.9% over the same period. The trade weighted U.S. dollar index gained 2.5% against major currencies even as safe-haven sovereign bond yields collapsed across the globe as investors rushed away from risky assets. US ten-year treasury yields fell 28 basis points over the two-day period, to 1.46. German Bund yields collapsed into negative territory for the first time in history, falling 21 basis points to -0.12 by Monday. The Japanese yen also appreciated in safe-haven trading, rising 4% against the U.S. dollar to 101.66, its highest level since July 2014.
Equity markets rebounded strongly to close out the quarter thanks to central banks across the globe reiterating that they were ready to do what was required in terms of backstopping the global economy and financial markets. The S&P 500 index finished the second quarter up 2.5%, while the MSCI EAFE price index, representing large and mid cap equities across developed markets excluding the U.S. and Canada, fell -1.19% (USD terms). The MSCI Emerging Markets price index recovered significantly from a steep 8.4% drawdown between April and May to finish the quarter with 0.80% (USD terms). MSCI ACWI posted 1.19% (USD terms) for the 2nd quarter while Barclays U.S. Aggregate Index closed the quarter with 2.21%.
The Spouting Rock/Convex Dynamic Global Macro Fund (CVXIX, Institutional Class) gained 1.75% in the second quarter of 2016. As of 6/30/16, the Spouting Rock/Convex Dynamic Global Macro Fund average annual returns since the fund’s inception on 11/24/14 are -0.20% for CVXIX and -0.53% for CVXAX. The returns for the 1-year period ending 6/30/16 are -1.48% for CVXIX and -1.89% for CVXAX.
The Federal Reserve Holds
The U.S. economy continued to stand tall in the second quarter, powered by the consumer. Real GDP growth, which came in at 1.1% annualized growth in Q1 2016 (third estimate), is expected to grow between 2-3% in Q2 (Atlanta Fed GDPNow forecast). Real consumer spending growth is expected to grow 4.4% year-over-year. While auto sales have softened some from their decade highs in October, sales continue to remain strong. Home prices are also maintaining their steady climb upwards, providing a further boost to the American consumer. Consumer confidence rebounded in May and June, as household balance sheets have gotten stronger amid real wage gains. This is belied in the fact that household debt service fell to 10% of disposable personal income in the second quarter, the lowest level since the early 1980s.
The good news on the consumer front was partially offset by a terrible payroll report for May, which saw only 38,000 jobs created during the month, the lowest since September 2010. April job creation was also revised down to 123,000 (from 160,000). This compares to a monthly average of 224,000 jobs during the first quarter and 229,000 in 2015. It is important to note that monthly job numbers have a high degree of variability and a strike at Verizon cut job growth by about 37,000. Headline unemployment fell to 4.7%, but even this was because fewer people reported looking for work. At the same time, wages continue to grow around 2.5% annually, and since core inflation is running less than 2%, there has been some real wage growth.
For a Federal Reserve (Fed) that reminds us at every juncture that they are data dependent, the data really threw them a curveball before their June meeting. While a data dependent approach seems like the obvious choice on the face of it, it does put one at the mercy of data that can point in different directions at the same time. May’s payroll report, along with financial stresses abroad, including those faced by China, and more immediately, the potential for Brexit, led the Fed to hold off on raising rates at their June meeting (held a couple of days prior to the British referendum). With British voters actually voting to exit, and the specter of uncertainty it has raised going forward, it seems unlikely that the Fed will raise rates more than once in 2016, if at all.
The Fed stepping back from the pedal of monetary policy tightening during the first half of the year led to a pullback in the dollar over the first five months of the year. A weaker dollar, along with rebounding oil prices, has helped the manufacturing and export sectors, reversing the trend from 2015.
The big question is whether there will be spillover effects from the Brexit vote. The United Kingdom accounts for only 4% of world GDP and about 3% of U.S. exports. So the direct impact should be minimal, and financial markets are clearly buoyed by a Fed that appears wary of tightening amid global stresses. At the same time, the biggest concern is whether the U.S. dollar will continue to strengthen, stanching any recovery in the industrial sector. While personal consumption accounts for close to 70% of the U.S. economy, and manufacturing just about 12% of it, the latter is over-represented in S&P 500 earnings. It remains to be seen whether the tailwinds of a lower dollar and stronger oil prices will fade away as investors rush toward safe havens in the second half of the year.
Convex’s proprietary leading economic index (CPLEI) rated the U.S. as “Hold” through most of the second quarter, indicating on-trend economic growth. The portfolio’s exposure to domestic equities averaged close to 40% throughout the quarter and contributed one percentage point to the fund’s 1.75% return for Q2.
European banks, finally on the mend after the 2008 financial crisis and subsequent Eurozone related emergencies, took the biggest hit after the Brexit vote. Banks have to decide whether to remain in Britain or shift operations to continental Europe. Up until this point, most global banks have set up shop in the United Kingdom and done business in the EU by “passporting” into the rest of the 28-member bloc. London is also a major center for clearing and settling trades for EU securities, a status that is now under question.
It is not clear as to what happens next. While there are several potential paths Britain can take, the hurdles are mainly political. No country has ever left the EU before and there is no roadmap in its charter as to how a country can negotiate an exit. Once Britain invokes ‘Article 50’ of the EU treaty, which formally announces the intention to exit, a two-year clock starts for the parties to negotiate terms of divorce. Britain will immediately cease to be a member of the EU at the end of those two years, whether or not an agreement has been hashed out – which could significantly disrupt business, trade and travel.
Europe’s economy continued to recover in Q2, with the unemployment rate falling and manufacturing staging a recovery. The region should also benefit from less austerity and pent-up demand amid oil prices that are more than 50% lower than two years ago. However, Britain voting to leave the EU has resulted in a dark cloud hanging over the region’s future. There is some hope that the remaining EU countries may come out stronger by the end of it, without a Britain that has always been ambivalent about its relationship with Europe. However, this is only conjecture at this point.
Even though the European Central Bank (and the Bank of England) has made clear that it will do everything possible to mitigate the economic and financial repercussions of Brexit, there are questions over the potency of ever more accommodative central bank policies, especially negative interest rates. In any case, the uncertainty over Brexit may have ended some of the optimism around Europe’s economic future in the near and medium-term.
Convex’s proprietary rating for Europe held at “Caution-Hold” throughout the second quarter as uncertainty grew over “known-unknown” risks arising from a potential Brexit. The fund portfolio had only a 7% allocation on an average to European equities during the period. European equity exposure dragged the fund return down by -0.25 percentage points.
The portfolio also maintained a very low allocation to Japanese equities in Q2 (about 1%), even as the CPLEI rating for Japan rose to “Hold” in May and June. Similar to Europe, concerns over the effectiveness of negative interest rates and rising volatility around the British referendum held us back from raising exposure to Japan. The Japanese yen has also appreciated close to 15% against the U.S. dollar in 2016 and is trading at levels close to those seen at the beginning of 2014, putting pressure on exporters. This has negated one of the ancillary effects of massive monetary stimulus put in place as part of Abenomics, i.e. a lower currency. It remains to be seen whether the Japanese central bank will step in with further easing measures to prevent the yen from rising much further.
The portfolio had no allocation to Emerging Markets (EM) during the second quarter, as a “Caution” rating persisted. EM caught a reprieve in the first half of 2016 as the dollar weakened and energy prices rebounded. However, the region continues to be dominated by concerns over China and its transition to a more consumption dependent economy. Post-Brexit, we are even more cautious given the uncertainty over the impact of a rising dollar on EM markets, and the ability of companies in the region to pay back dollar denominated debt.
A “Caution-Hold” risk rating for the world, combined with concerns over “known-unknown” risks around the British referendum, led us to hold a more conservative portfolio in the second quarter. The fund averaged a 42% allocation to fixed income and a 7% allocation to cash during the period. Fixed income exposure contributed 0.78% to the fund return in Q2. Within the asset class, intermediate and long-term bonds (treasury and corporate), which averaged a 27% allocation, contributed 0.68%.
Some events are true black swans – for example, the September 11th terrorist attacks or the Tsunami in Japan – one-off events that create immediate financial panic, but may or may not exacerbate underlying economic vulnerabilities. However, Britain’s vote to leave the EU is different in that it is a manifestation of underlying forces of populism that have been building for years amid low economic growth and loss of faith in traditional institutions, which have promoted liberal immigration and trade policies, let alone monetary policy that appears to have lost its bite.
As we noted above, Britain accounts for less than 4% of world GDP but the forces made stronger by Brexit is what makes the situation more than just an immediate economic threat. The resulting political upheaval creates a much wider range of possible outcomes, creating ever more uncertainty for the global economy and financial markets.
Our proprietary risk rating for the world remains at “Caution-Hold” going into the second half of the year as we continuously monitor the economic situation of thirty different countries across five regions. We remain vigilant about identifying potential risks arising from the aftermath of the British vote and any other risks that can adversely impact financial markets and the Fund’s portfolio.
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