British citizens went to the polls on June 23rd and, to the surprise of many and the applause of bookmakers, voted to exit the European Union (“E.U.”). Markets convulsed as investors across the globe grappled with the possible ramifications of the “Brexit.” What does this mean for the world economy? And, more specifically, what are the implications for growth here in America? We believe that it is still premature to gauge the full impact of this vote beyond what could likely be an extended period of uncertainty on the part of investors, economists and politicians. As we have pointed out in the past, markets can usually adjust to even the worst headlines, but extended periods of uncertainty can have a corrosive effect on business confidence and economic growth. Central banks around the world do not have much gunpowder left beyond an even deeper dive into the netherworld of negative interest rates. As we have seen to date, this has distorted financial markets, consumer psyches and banking system vitality. It has not resulted in economic growth, inflation, increased lending by banks or capital spending on productive capacity. How are we as investors to navigate these uncertain waters?

We don’t think that Britain will completely disassociate with the E.U. As you may remember, in 1994 Norway voted against joining the E.U. but pays into the union and continues to abide by some E.U. rules in order to continue to enjoy open borders and free trade. Britain may end up in the same situation. At present, Britain’s exit is only a mandate of the people, not yet a law, and still needs to be acted on officially by the British government. The mechanism for doing so was included in the 2007 Treaty of Lisbon: Article 50 of the treaty outlines the framework by which a member state can exit the E.U. Invoking Article 50 starts a two year clock during which Britain and the E.U. will negotiate the terms of exit. During this process, Britain will no longer have a voice in the European Parliament and the remaining 27 members of the Union must vote unanimously on the terms negotiated. Since Article 50 has never been used before, one could safely say that delays, deadline extensions and a lot of muddling through are likely. David Cameron, who announced his resignation as prime minister following the vote, intends to leave office and hand the implementation of the referendum to his successor. The next prime minister will go down in the history books as the one who “pushed the button” (so to speak) on Britain leaving the E.U. If the economy takes a material turn for the worse and promises made during the “leave” campaign are not met, the political blowback could be severe. We would not be surprised to see some backpedaling and possibly another vote on the matter. European Council President Donald Tusk hinted that these negotiations could drag on for up to seven years and could be acrimonious. At the very least, the business community will have to make capital allocation and personnel decisions in somewhat of a political and regulatory vacuum. On the bright side, it is possible that the electorate and the European appointees put politics aside (a long shot, but one can be hopeful) and are decisive in hammering out a workable arrangement allowing business and trade to resume somewhat normal operations. Time will bring clarity to what path is chosen.

What are the implications for the U.S. economy? In 2015, the U.S. exported $56 billion to and imported $58 billion from Britain. By contrast, our combined exports to Europe, China, Canada and Mexico last year totaled $953 billion, and our combined imports from these same countries totaled $1,5646 billion. As you can see, while we value our relationship with Britain, our trade with them is not material, representing about 3% of our total. Viewed another way, it represents a bit less than 4% of U.S. exports and less than 3% of U.S. imports. And since exports only comprise approximately 13% of U.S. gross domestic product (“GDP”), exports to the U.K. therefore represent only about 0.5% of total U.S. GDP. If these were to decline by 25% it would be a rounding error. Based on these numbers, we feel that the market’s immediate reaction was more emotional than based on the data.

We found recent comments by Mario Draghi and Janet Yellen quite interesting. First, prior to the vote, Mr. Draghi announced that he was prepared to act if there was turbulence in the markets. He has in the past used suasion to improve market sentiment. Does anyone remember his now famous “whatever it takes”? We do. He is very direct and the markets seem to respond well. Ms. Yellen, on the other hand, continues to confuse the markets by trying to appease both hawks and doves alike. In her June testimony she was asked if the Federal Reserve (“Fed”) was targeting the equity markets as a “third pillar” of Fed policy mandates. She answered "We do not target the level of stock prices," adding “That is not an appropriate thing for us to do." You could have fooled us, Janet! While her answer may have been technically accurate, we believe that equity markets do inform Fed policy, even if they are not explicitly targeted. It is fairly obvious that central bankers are very much in touch with the pulse of the markets and when turmoil strikes, they are front and center in trying to avoid a big rout, using whatever means they have ranging from suasion to market intervention.

Given the cloud of uncertainty that may hang over the markets regarding Brexit developments, we expect central bankers to remain extremely accommodative, in both speech and actions. In fact, we are currently seeing a persistent battering of Treasury rates lower in the U.S. and fear that if it continues, we may tip into a yield landscape equal to that of much of the developed world, specifically zero to negative interest rates. The implications for this could be meaningful for other asset classes, such as corporate credit. Once the yield bearing trees are laid barren by the hordes of yield-hungry locusts, they will turn their attention to other yield-bearing flora. In Europe, for instance, nominal yields on high yield bonds have been much lower than those found in the U.S. market since late 2012, following Denmark’s policy move into negative rates. This is partly explained by the somewhat shorter duration of the European high yield market, but more so by the much lower nominal yields on sovereign debt there. Our conclusion is that if the U.S. Fed is willing to let rates drop across the curve to the zero bound and possibly lower into negative rate territory, it will provide a very good backdrop for other asset classes, especially higher yielding corporate bonds. We would expect a similar experience here to what has happened in Europe as sovereign yields dropped to negligible levels, namely a revaluation of corporate yields and lower spreads (read: higher bond prices).

The consequence of this scenario could be handsome returns in corporate credit, with returns laddered by rating tiers (e.g., highest returns for lowest rated tier). The already low financing costs to issuing companies would continue to drop, thereby offsetting some of the possible impact of slower economic growth. The flip side of this coin would be that when the next recession hits, central banks will have exhausted much of their arms cache. Since they are notthe most imaginative organizations, we would expect them to push rates even lower into negative territory, much like Mr. Kuroda is doing at the Bank of Japan. Sadly we don’t think this would be very effective at stimulating growth nor at boosting business confidence, which has already taken a hit following the Brexit vote.

As we have said before: negative interest rates are not normal. They distort markets and prevent both rational price discovery and creative destruction. Both are necessary to build a new foundation for sustainable, healthy growth. Putting aside geopolitical unrest and rising global tensions for a moment, we still believe that some companies will continue to do well in this environment. Economies rarely implode into gridlock. Economists and market pundits typically view an economy that is not growing or one that is shrinking at a few percentage points a year as an unmitigated disaster. It is not. An economy that is shrinking by 2% a year is still operating at 98% of what it was the year before. People are still buying and companies are still producing and selling goods, albeit a bit fewer than before. With declining birth rates in many parts of the developed world, might we better tolerate slower baseline economic growth? This may also partially explain the lack of inflation in the face of massive monetary stimulus but we will leave this question for the demographic economists to ponder.

It appears that we are at a fork in the road: we can either buy U.S. sovereign debt (e.g., Treasuries) on the assumption that yields will drop even further toward zero in the near future (a bird in the bush); or, we can invest in bonds with a higher nominal yield today (a bird in the hand) that may also participate in price appreciation due to additional declines in nominal rates in the corporate sector. The “bush” approach requires us to make a bet on a continued and persistent decline in rates; the “hand” approach does not and also holds out the possibility that we could benefit beyond the capture of higher interest rates today with a possible revaluation if interest rates decline further. Our long-term investors know we prefer a “bird in the hand” approach and therefore understand why we are focusing on corporate, rather than sovereign, debt.

Looking ahead we believe the markets could exhibit bouts of volatility as we approach elections here at home and as developments unfold in Europe. We continue to build cash both as a defensive tactic and as a strategic reserve of buying power so we are ready when opportunities present themselves. We have been adding selective convertible bond issues during recent bouts of equity weakness and have our shopping list ready for more; all we need is lower prices! Hopefully our clients realize that mark-to-market declines allow us to make purchases at attractive prices and eventually, we should revert to a more rational pricing environment.

Thank you for your continued support. As always we are trying our best to avoid areas we perceive as risky and are looking for market dislocations in order to buy securities that we believe offer good value.

Sincerely,

 
 

Carl Kaufman Simon Lee Bradley Kane

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Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.

Yield is the income return on an investment.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.

Duration measures the sensitivity of a fixed income security's price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

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