Second Quarter 2016 – Quarterly Commentary


Grexit, Brexit, Frexit… or, Parting is such sweet sorrow!
(with sincere apologies to William Shakespeare)

Once upon a time (2012 to be exact) the world chose to worry about a newly coined phrase called: “Grexit”. At the time, this newly minted term meant that Greece, which amounts to a mere 2% of the economic output of the Eurozone, might be the first country to leave the EU. Panic ensued but Greece, in spite of its economic misery and newly elected extreme left-wing governing SYRIZA party, stayed in the fold. Collapse averted, order restored.

Fast forward to 2016. After a whiplash first quarter the second quarter seemed reasonably tame until British electorate thumbed their nose at the experts and voted YES to “Brexit”. The focus has now shifted from the peripheral countries in the EU, about which relatively little has been heard recently, to one of the “big four”- in this case, Great Britain. Three years ago the Prime Minister, David Cameron, rashly promised to hold a referendum on Britain’s continued membership in the EU after he had gone to Brussels to “renegotiate” the terms upon which it would stay in. He did indeed go to Brussels earlier this year, got some concessions and, a little akin to Neville Chamberlain’s “Peace in our time” moment, returned to London waving the improvements and urging Britons to vote to “Remain” in the EU. Those who saw life differently, or ranked their priorities differently, were referred to as “Brexiteers” and they had many senior government and even business officials on their team.

The vote was duly held on Thursday, June 23rd and, by a relatively thin margin of 52% to 48%, the British public voted to “Brexit” the EU. Initially the global capital markets, caught completely offside went into a tailspin, equity and currency markets were roiled around the globe (Tokyo down 8%, Frankfurt down 8% and New York off over 3%). Shares in the UK banking sector got slaughtered (see chart for the three clearing banks: Royal Bank of Scotland, Barclays and Lloyds) as did the home builders. Confidence in Sterling was shattered dropping to a 30 year low of 1.32 to the US dollar and millions were left wondering a) what have we done? and b) where do we go from here?

gbp

The very first person to lose his job in the UK was the Prime Minister, David Cameron, that very night. He has since been replaced as Prime Minister by Dame Theresa May. Interestingly right after the referendum was won both Boris Johnson and Nigel Farage the ringleaders of Brexit announced that their job was done and they were stepping down. Johnson has since accepted a cabinet post in the new government.

By the end of the week most markets had recovered and the UK Stock market was above the level at which it was before the referendum and up 7.03% on the quarter. The FTSE 250 which is a broader index and likely more reflective of the British economy as a whole is still 4.5% below where it was before the Brexit vote.

rbs-lyg-bcs-ycharts

The venerable British Pound which bounced a little and has commenced on its downward journey to levels last seen during the days of brownouts that brought England’s Dame Maggie Thatcher into power. Overall, markets around the world have now recovered from the hectic events of Brexit. We believe that little will happen in the near future but certainly Brexit will be a catalyst to Europe reviewing their membership requirements and over time the single currency experiment will likely come under attack as will the “United States of Europe” concept. Already the skeptics around Europe are lining up to appeal to their respective governments to hold their own referendums. In fact, there is a joke making the rounds which goes as follows: “BREXIT could be followed by GREXIT, DEPARTUGAL, ITALEAVE, CZECHOUT, OUSTRIA, FINISH, LATERVIA and BYEGIUM. Only REMAINIA will stay”. Ha-ha. If it weren’t so possibly true, it would be funny.

Brexit was undoubtedly the most exciting news of the quarter but in overall terms the markets for Canadian investors were quite well behaved. The TSX Composite returned 4.23% led by the Materials sector and a recovery in Energy prices. The US markets also had positive returns with the S&P500 up 1.9% on the quarter. Canadian bonds completed the third leg of a positive triumvirate with composite returns of 2.6%.

Musings for the Capital Markets

Normally at this time of the year one is advised “sell and go away”. Indeed, there may be a pullback in the equity markets as we go through the balance of the summer and the fall but this might well be a “buy on dips” opportunity. There are two key reasons for a feeling of well-being in this current environment. The first is that given the reaction of markets in the immediate aftermath of the Brexit vote the central banks and particularly the U.S. Federal Reserve will be reluctant to roil the markets with interest rate hikes. This is insurance to investors that the equity market rally will not be killed by the US Central Bank. It might however be much more than this, as low interest and mortgage rates are providing potential US homeowners with a compelling reason to buy new homes. “Oh No!!” you might say, “millennials want to stay home with Mom and Dad and sponge off them for the rest of their lives and in any event they can’t find suitable employment or afford to buy a house”. Look at the job situation in the US “nobody is working and thus there is no money”. As it turns out this conventional wisdom is wrong.

On the home affordability question let’s look at the US Fixed Housing Affordability Index (top chart).

ycharts-us-housing

This is a measure of the affordability of a median house for a household with median earnings based on the current mortgage rates. What it shows is that home owner-ship is in fact relatively affordable to most people and is trending in the right direction. The second chart shows that house vacancy rates are falling and if this trend continues there will soon be a shortage of housing which will lead to new home building and this is borne out by the rise in building permits shown in the third chart.

Home building in the US is one of the largest employers in the country and thus any increase in house building activity will have a positive impact on the GDP of the country, the extra wages generated will also add to consumer spending triggering a virtuous circle of spending creating more spending and adding a strong impetus to US GDP. The fact that the Fed will likely stay on the sidelines is all the more positive for this view.

Now on to the workforce dilemma. Conventional wisdom also suggests that since 2008 there has been a rise in disaffected workers who have stopped looking for jobs and therefore the unemployment rate is skewed downwards and is not reflective of the true state of the US labour force.

us-age-demographics

First let’s look at the demographics of the country. As you can see in the chart the size of the baby boom echo and the millennial generation is far larger than the baby boom generation, which is now leaving the workforce. This tends to get lost when people see many aging boomers retiring and not spending as much. However, these larger generations are now coming into their peak earning and spending years.

This explains the following chart where we saw a huge loss of jobs and rise in the unemployment rate after the Financial Crisis of 2008 and a very quick drop in the unemployment rate following. If we compare the dates we will find that many people in the early and mid-sixties left the work force and

non-farm-payrolls

they are now retired. Thus the labour market is quite tight in the US right now and wage growth inevitably follows low unemployment rates as those indicated by the red line.

In addition to this, US household leverage is back to the levels it was in the nineties and, with much lower interest rates, households are in fine shape from a debt point-of-view.

This means the active workforce is in a position to spend. We believe this bodes well for the US economy over the medium term.

The second factor that is encourage ng to us is a bit more esoteric and revolves around the natural ambitions of all those in power to stay in power. In this case we are referring to none other than the paramount leader of the largest country, population wise, on earth Mr. Xi Jinping the President of China. He is both the President of China and the General Secretary of the Communist party. As such he is elected to a five year term renewable for one term. His first term comes due in about eighteen months and thus it is important to Xi to have a strong economy at the time of his re-election in early 2018. We have reason to believe that he intends to reflate the Chinese economy over the next six to twelve months so as to have a strong economy in place in time for his re-election. We shall be monitoring this situation but find it credible and thus once again a good reason to be fairly constructive on the market in the near to medium term.