Brexit, Fed: a short squeeze

If in the short-run the market is a voting machine, as attributed to value investor Benjamin Graham, yesterday’s 3% rise in European markets represents a vote of confidence in the Remain campaign winning the UK’s referendum on Thursday and a consistently more dovish US Fed for the remainder of the summer.

Though there remains a significant degree of uncertainty in the referendum outcome, the improved polling for Remain in recent days is consistent with previous swings towards the status quo seen in other European referenda as the voting date nears. Commodities, bonds, credit markets, equities and FX have all been tracking the Bremain/risk on Brexit/risk off trade in recent weeks, limiting the benefits of portfolio diversification.

It is in fact an alarming demonstration of the fragility of the current global economic system that a nation accounting for 2.4% of world GDP with perhaps 10% of that volume at risk from Brexit – or 0.24% of world GDP – can trigger such large gyrations in global markets.

We believe this once again illustrates how close investors are standing to the exits, with risk premia low and pre-crisis levels of growth still elusive. The 70% year on year decline in UK M&A volumes and steady outflows from UK investment funds over the last 12m shows just how cautious both corporate and portfolio investors have become leading up to the UK’s referendum.

In the context of this investor positioning, we believe the combination of a more dovish Fed, the absence of a crisis in China and the recent swing in the Brexit polls towards Remain has triggered a global short squeeze; the question now is how far it might run.

Before market volumes thin out over the summer, there is a further Fed meeting on 26-27th July and short-term investors will want to have confidence there will be no unpleasant surprises. In that respect, during the most recent Fed press conference Fed Chair Yellen stated that it was “not impossible” that by July’s meeting there would be evidence of sufficient momentum in the US economy to raise US rates.

We believe the choice of the phrase “not impossible” indicates the Fed’s current thinking is that September is likely to be the earliest date for a rate increase, by which time there may be sufficient new data available to persuade Fed policymakers to become more hawkish (again), having lowered forward policy expectations so significantly in June.

Therefore, while we have cautioned that markets are expensive and bond markets and survey data indicate a slowdown in US economic activity lies ahead, following a Remain vote in the UK and provided there are no negative developments in China we may see markets continue to trade higher ahead of the summer lull in activity.

Exhibit 1: 2016 EPS revision indices

This is a tactical call and if markets were to rise significantly from here without a commensurate increase in earnings expectations (and at present such earnings momentum remains elusive across the US, UK and Europe, Exhibit 1) we would suggest investors respond to any monetary policy and relief-led rally by lowering equity exposure. Valuation, profits growth and global political risks remain in place, regardless of the UK’s referendum verdict.