“… the only way to guarantee you have nothing at retirement is to invest nothing along the way.” – John Bogle, founder and CEO of Vanguard Group
The purpose of this quarterly commentary is to communicate with you about our thoughts on the markets, provide some snap-shots of market metrics, and provide an overview of topical issues; however, it will also be married with some aspects of our recently initiated monthly commentary, in order to provide you with a succinct update of our views on the market, without the need for two separate communications. We hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.
Brexit: The Aftermath
By now, you are likely tired of hearing the word Brexit, the Portmanteau used to describe the United Kingdom referendum which resulted in 52% of the population voting to leave the European Union. The result was highly unexpected, with most high profile polls placing the probability of a ‘leave’ victory at approximately 25%. Following the result, there has been endless speculation in regard to what may happen, however, we believe that there has not been enough discussion outlining what actually has happened in its wake. Therefore, to start, we wanted to outline what the immediate impacts have been, following the Brexit vote.
From the perspective of international stock markets, the net effect to date has not been what anybody would refer to as catastrophic. The FTSE 100, which accounts for the 100 largest companies traded on the London Stock Exchan
ge, is actually up 4.5% since the result of the vote. The FTSE 250, which is comprised of the next 250 largest companies, outside of the top 100, is down 6.5%. Both of these figures hardly seem to indicate substantial investor concern. Here at home, the TSX is up just under 1% since the vote, while the S&P 500 is up 0.3%. Although individual stocks have been affected differently, this performance resonates with our opinion – which we stated in our interim commentary – that this result would not have a meaningful near-term impact on our domestic markets as a whole.
The currency markets have exhibited the most activity in the wake of the referendum, with the Great British Pound (GBP) relative to the U.S. Dollar (USD) exchange rate receiving most of the attention. The GBP has fallen almost 13% relative to the USD, to a 31-year low, while also falling approximately 11.5% against our CAD. While possibly beneficial for UK exports and tourism, this drop in currency also represents negative forecasts for UK economic growth.
The depreciation of the GBP, as with any other currency, is bitter sweet; while it may be a boon to UK manufacturing and tourism, it also represents negative sentiment in regard to UK economic growth and lower purchasing power for UK citizens. Alternatively, these sorts of currency swings need to be considered when analyzing large blue-chip companies with international operations; with a stronger USD, earnings and revenue figures for these companies may come under pressure. However, it should also be noted that 70% of revenues of S&P 500 companies are still derived domestically.
From a local perspective, the most drastic immediate impact on the UK economy has been the emergence of uncertainty. Financial markets and corporations alike both favour certainty and predictability, and uncertainty often results in lower hiring and capital expenditure, both of which are key to economic growth. For example, BBC reported “the share of businesses that reported feeling pessimistic about the UK economy doubled in the week after the Brexit vote.” The report also noted that the index that measures the expected capital expenditure of UK businesses fell from 108 to 100.1, slightly above the key level of 100, below which indicates a contraction of spending. Additionally, CEB, a consultancy, announced that the number of advertised job vacancies in the UK dropped by 47%, or 700,000 jobs following the referendum. We expect that both capital expenditure expectations and job adverts will rebound slightly in the near future, as these figures were likely indicative of an initial over-reaction; however, the data points serve a stunning example of the real economic effects of uncertainty.
Perhaps the largest immediate effect, however, has been felt within the commercial Real Estate industry, with the UK REIT Index falling 20% since the vote and seven commercial real estate funds have had to freeze retail redemptions due to a surge in liquidity requests. These funds invest in low liquidity real estate and have been unable to meet the demand for redemptions that have been requested since the vote. This collapse has been driven by the previously mentioned wave of uncertainty in regard to the UK economy, as well as fear of waning foreign and business investment. In turn, the massive demand for liquidity may likely result in these funds selling their properties prematurely, adding to the supply of the market and further exacerbating the price decline. Exhibit 1 below shows the dramatic decline of the UK REIT index.
There have also been immediate developments politically, with ex-London Mayor Boris Johnson –whom many pegged as the most likely candidate to be the next Prime Minister – announcing that he will not be running for office, and UK Independence Party Leader Nigel Farage stepping down from his post. Both have been widely derided for their actions, as they were seen as the two leading figures of the ‘Leave’ campaign.
Although fire and brimstone are yet to be sighted, the immediate impact of the Brexit has been fairly drastic in a few select areas of the market, namely commercial real estate and the financial sector. Most of immediate negative impacts are specific to either the local UK or European markets, and are unlikely to negatively affect our holdings. The one consideration that we remain cognizant of is the effect of currency translations on international companies, but we are actively attentive to this development.
Flight to Safety
As can be seen on page one, the clear winner of the current economic environment has been defensive equities and gold miners or other precious metal stocks, which benefit from the proverbial ‘Flight to Safety’ trend. North American Government Bonds have also benefitted for the same reason. These types of assets tend to represent stable sources of cash flow, stores of value, or both, and benefit from massive demand and capital flows in times of uncertainty. To illustrate, refer to Exhibit 2 below to see the surge in demand for gold, across its various uses.
Despite the massive surge in demand for gold as an investment, the other important factor to note is relatively low growth of global supply. Several years of poor bullion prices have caused many miners to decrease capital expenditure, which has worked to hamstring supply expansion in the near term. Moving forward, if demand continues to grow at a much faster rate than supply, it is expected to greatly benefit the value of gold. Demand for gold as an investment was particularly strong from ETF inflows, which added 363.7 tonnes of the yellow metal; this was the largest single quarter ETF demand figure since the first quarter of 2009.
Gold bullion has rallied 7.6% since the result of the Brexit vote, which is encouraging to gold investors due not only to its implication on gold miner profits, but also because its parallel rise with the USD. A rising USD is consistently quoted as being a headwind to higher gold prices, but this recent performance serves as an example as to why this statement is not necessarily canon.
This fact can be seen by observing a graph of the relationship between the USD and the price of gold, which can be seen in Exhibit 3 below.
This chart shows that, although there seems to be a strong correlation at times, the relationship is not perfectly negative and can certainly move in the same direction.
UBS Group AG has recently stated their opinion that the recent surge in gold is not a short-term bounce, and is rather indicative of the next leg of a bull market. This statement is supported on a momentum base by noting that the gold price has surpassed its own 20, 50 and 200 week moving averages, which is a strong indicator of forward momentum. From a valuation perspective, the value of gold mining stocks, relative to bullion prices, is currently quoted at a ratio of 0.18. The historical average of this figure has been 0.36, and the 2011 bullion price peak equated to a ratio of 0.62. Based on this statistic, despite their massive run year-to-date, the gold mining stocks still exhibit massive upside potential, even without higher bullion prices.
We continue to monitor the ongoing uncertainty in Europe, with an increased vigilance to protect client capital from increased volatility and uncertainty.
MacNicol & Associates Asset Management Inc. July 2016