Brexit is the biggest electorate riposte yet to The Age Of Inequality created by policymakers to save (some) of the world, and as BofAML's Michael Hartnett warns, investors must anticipate a shift to an increasingly populist policy response. The backdrop of Quantitative Failure nonetheless means a renewed bull market in risk assets is impossible unless fiscal policy can quickly arrest the downside in GDP & EPS forecasts.
BREXIT & the War on Inequality
In 2015 London accounted for 28% of all English housing sales despite accounting for just 1-2% of the total land area. BREXIT is thus far the biggest electoral riposte to our Age of Inequality.
Our secular conclusion is that investors must start to anticipate new populist policy responses & position for:
- higher levels of gold, volatility & cash,
- Main Street assets to outperform Wall Street assets, and
- outperformance of an uber-barbell strategy that plays to the reality of deflation and the anticipation of more desperate inflationary policy responses.
The Brexit vote was a shock to Wall Street because an electorate in a country with no economic or financial crisis voted to dramatically change its political status quo. This partly reflects the fact that economic recovery in recent years has been a. deflationary and b. unequal. Wall Street has prospered; Main Street has not (Chart 2).
Extreme monetary stimulus has failed to deliver a knockout blow to Deflation. The global economy remains stuck in a deflationary expansion of minimal growth & minimal rates. And electorates are increasingly voting in the developed world against wage deflation, high unemployment, immigration & inequality. Thus the failed “War on Deflation” is soon giving way to a “War on Inequality” which could feature the following:
1. Trade protectionism: this is most bullish for gold & volatility, most bearish for equities & credit. Trade tariffs, capital & labor market controls, and the constant threat of a currency war are likely to be very negative for corporate "animal spirits". Investment and jobs are unlikely to be boosted by protectionism.
2. Regressive taxation/higher minimum wages/regulation for higher bank capital: this is most bullish for bonds, especially Treasuries & US Munis, at the expense of cyclical stocks & banks. Higher taxes on rich will likely hurt small business confidence & entrench the "deflationary expansion”. Minimum wage increases would simply exacerbate wage deflation as companies replace humans with robots to keep margins/profits high (Chart 3). Higher capital in the banking system, perhaps in lieu of Fed rate hikes, is unlikely to spur credit expansion.
3. New Deal fiscal stimulus financed by helicopter money: this is most bullish for risk assets, but would most likely be in reaction to a recession and bear market (sadly options 1 & 2 are more politically viable). "Helicopter money” (central bank printing) to directly finance tax cuts for the poor, infrastructure spending (can you think of a better time for infrastructure spending with rates so low, commodity prices so low and private equity flush with cash?) and/or the introduction of "living wages" are policies that have the best chance of boosting both growth & inflation expectations over the next 2 years. Fiscal stimulus is the best route to jump-start the zombification of aggregate global demand. Japan’s “Takahashi Economic Policy” of 1932-36 is the best example of successful fiscal expenditures backed by deficit financing with the central bank’s credit. And Japan once again is the most likely location for this next chapter of policy easing (driven by excessive yen strength).
Bond yields will be the barometer of Regime Change. Policy makers must induce a "good" rise in bond yields via fiscal policy. But their response won't happen overnight. In the meantime, investors should adopt the following 3 strategies:
1. Investors should continue looking for opportunities to add to their positions in gold and volatility; we would expect cash levels to remain high. Gold, vol & cash remain our favored positions to play the "Twilight Zone" of the QE-led bull market in risk assets.
2. Investors should be long Main St plays (e.g. regional banks & mass retailers), and short Wall St plays (e.g. broker/dealers & luxury retail). Policy makers will aim to maximize the spending power of the poor and minimize the spending power of the rich.
3. Investors should be long an “uber-barbell” of high-growth/high-quality stocks (F.A.N.G., global Best-of-Breed stocks and "yield plays") and underowned inflation assets (commodities, TIPS, EM and the UK). The high-growth/high-quality tail of this barbell reflects the fact that deflation and the collapse in all global rates to zero will exacerbate the rich valuations in these sectors. The more controversial belief in "inflation assets" reflects the distressed valuations that appear in these assets and the anticipation that policy will ultimately have to reverse the slump in inflation expectations. Two good hunting grounds for the secular contrarian: UK stocks…currently at 40-year lows versus Developed Markets (Chart 4)…
And commodities…where the rolling return is currently at 80-year lows (Chart 5).
BREXIT Trades
BREXIT caused a plunge in global equity market capitalization of ~$3tn (to $60tn) and expanded the universe of negative yielding debt to $10tn.
BREXIT is an exogenous shock. It will lead to lower growth, lower rates & a stronger dollar. But it will also lead to a short-term tactical buying opportunity for risk assets, led by credit markets, once redemption fear passes and policy makers respond. The backdrop of Quantitative Failure nonetheless means any sustained rally in risk assets is unlikely unless policy can quickly arrest the downside in GDP & EPS forecasts.
Our economists have cut growth estimates as follows:
- US GDP cut from 2.0% to 1.8% in 2017 (Table 1);
- Eurozone GDP cut from 1.6% to 1.1% in 2017;
- UK GDP cut from 1.7% to 1.4% in 2016 and 2.3% to 0.2% in 2017.
On policy, BofAML have adjusted expectations as follows:
- Fed to postpone its next hike to December;
- Bank of England to cut its rate 50bps and announce £50bn in additional QE;
- ECB to announce the extension of QE in July.
Our investor feedback: cash levels are high, but redemption fear is just as high and performance poor; hence big reluctance to buy unless policy makers act.
Key to watch in coming days and weeks:
Positioning
Investors came into BREXIT hunkered down: global FMS cash at highest level since 2001; all-time low in UK sterling exposure; 20 straight weeks of outflows from European equities. A flush of redemptions in coming days would help form a low for risk asset prices. Under-positioning in sterling suggests this should also be a lead indicator for Risk-takers.
Policy
Markets stop panicking when policy makers start panicking. Central banks must exhibit coordination and persuade markets there is no risk of any solvency issues (the Black Swan event is rising yields as central banks lose credibility). Further pressure on LIBOR spreads, peripheral debt spreads, and European credit spreads must be resisted by central banks. Given ECB intervention in corporate bond markets, watch ITRXEBE Index (ITraxx Europe) like a hawk. Spread peaked in February at 126; it closed on Friday at 93; risk-takers should act if the 105 level can be defended.
Watch the yen. A clean break of JPY100 would make Japanese policy action likely.
More broadly, monetary policy is exhausted, so fresh belief in fresh policy initiatives is necessary to avoid investors discounting currency wars and protectionism.
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BREXIT has already been a big risk-off event. The combo of falling EPS and falling rates is not a good one for stocks or credit. But we think a barbell of gold and yield plays (staples, utilities, dividends, REITs) will outperform until investors see redemption pressures stabilize and contagion risks contained.
Start to nibble as we approach key short-term targets: GBP 1.30, 10-year bunds -20bp, SX5E 2700, SPX 2000, SXXP 300 & sell gold as it approaches 1450.
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