The second quarter of 2016 ended with a bang, as the United Kingdom voted to leave (“Brexit”) the European Union on June 23. This marked the second time in six months that global stock markets experienced severe stress, following the worst January in recorded history. Given the volatile environment, we have emphasized capital preservation to protect against an unexpected market shock or policy mistake. Similar to January, our strategies held up very well during this most recent “stress test,” smoothing the journey to fulfill our clients’ long-term goals.
In the immediate aftermath of Brexit, however, a bifurcated reaction occurred: investors sought safety and risk, as evidenced by rallies in both the bond and stock markets. The quest for safety drove sovereign bond yields to record lows while bidding up the price of precious metals such as gold and silver. The entire Swiss bond market moved into negative yield territory, Japan’s bond market was negative for issues up to 20 years in maturity, the German government sold a 10-year bond at a negative interest rate for the first time, and the US Treasury bond traded below 1.4% — matching an all-time low. Even some corporations were able to float debt at negative interest rates. In the past, nosediving bond yields have tended to presage severe slowdowns and oftentimes contractions in economic activity.
Yet, despite these signals, stock markets have quickly recovered in the Brexit aftermath. The S&P 500 index is trading at record highs, led by defensive, higher-yielding sectors such as utilities and real estate. In the context of ever-increasing bond prices with correspondingly low yields, many investors seem to believe their best option is to buy dividend-paying, defensive stocks.
As we enter the third quarter, it feels as if markets are walking a tightrope between safe and risk assets, with the activity so far in July seemingly tipping in favor of risk. Positive quarterly earnings and GDP reports could tip the balance even more in this direction; however, analysts are calling for second quarter earnings to fall further, on pace for the fifth consecutive quarter of sequential declines.
We believe today’s delicate equilibrium may be challenged – and ultimately redirected in favor of safe assets (as opposed to risk assets) – by three key sources of potential instability:
- The longer-term consequences of Brexit on the European Union. While immediate concerns have faded, the severity of the shock to global economic growth is yet to be realized. The United Kingdom is the world’s fifth largest economy, so consequences could be far more dire than those posed by last summer’s potential “Grexit” (Greece’s exit from the EU). Given Britain’s trading relationship with the European Union, the uncertainty and political turmoil surrounding the terms of the separation are likely to undermine economic growth in both areas. Furthermore, the solvency of the Italian banking system is already being called into question in the lead up to its referendum on constitutional reforms. It remains to be seen whether these events lead to long overdue structural reforms and a more cohesive fiscal union or, conversely, to a domino effect of “exits” and complete unraveling of the common currency.
- Exhaustion with monetary policy being the “only game in town.” To cushion the impacts of Brexit, markets now expect central banks around the world to double down on their efforts to stimulate growth with further unconventional monetary policy. The Bank of Japan is rumored to be considering “helicopter money,” the drastic step of permanently monetizing further budget deficits. This radical tactic is normally only discussed in textbooks — not as a practical policy alternative. The recent rallies in the yen, euro and gold, as well as the correction in financial stocks, point to concerns that central banks can no longer support growth without fiscal policy and structural reform. As a result, yield curves are flattening around the world, reflecting unprecedentedly low long-term inflation expectations. 
- The sustainability of Chinese economic growth. Rumors abound that China needs to devalue its currency as its credit markets and banking system come under additional strain. The Chinese stock market continues to languish in 2016 while other Asian markets have pushed new highs, suggesting these concerns cannot be ignored. While China’s woes have not grabbed as many headlines as they did last year, we think they remain an important element in global market activity. In early July, the rating agency Standard & Poor’s warned that China was on pace for a greater-than-average credit downturn. As the Federal Reserve (Fed) slows the pace of its monetary policy normalization, the US dollar is no longer appreciating as rapidly as it has in recent past. However, if the US economy continues to grow and inflation pressures increase with a healing labor market, US dollar expectations could change quickly.
While public markets walk the tightrope between safe and risk assets, our themes of capital preservation, high selectivity in public markets, and an emphasis on creative solutions within Manager Skill and Private Capital are likely to characterize our approach for the foreseeable future. As the ramifications of Brexit become clearer, markets will no doubt turn their attention to the all-important US political cycle this fall. As always, we are working hard to ensure our portfolios are properly positioned to take advantage of burgeoning opportunities.
The last time dividend yields exceeded sovereign bond yields in a sustainable way was the period before 1959 when bonds were routinely deemed to be riskier than stocks.
 “Making Sense of it All? What Capital Markets Will Tell Business Owners Before Economists Will” explains why we think this is a key signal about future economic growth.
 Standard & Poor’s, July 6th, 2016.