The Dividend Cafe - Not Out of the Woods – Brexit Part 2 and What it Means to You – June 28, 2016

Episode Date: June 27, 2016

David Bahnsen, Chief Investment Officer of The Bahnsen Group, sounds off more with ten observations about BREXIT and the market's response to it

Dear valued clients and friends, as all of you are likely aware by now, the citizens of Great Britain shocked the world last Thursday by voting to exit the European Union, the so-called Brexit. Markets reversed the gains they had made the previous five days. Our initial commentary can be found at DividendCafe.com, which we posted last Friday in direct response to the Brexit passage. We did not, unfortunately, have time to do a podcast of that version. But now, a couple days later, and with more market turmoil, we wanted to come with a second set of comments and analysis, both on our DividendCafe.com website and provide a podcast version of the same. This turmoil included the Dow being down 600 points or 3.5% last Friday.

The German DAX was down 7%. The Japanese Nikkei was down 8%. And the French stock market down 8%. With the London FTSE only down 3%. If you find the fact that it was the UK market which held up the best compared to all the others, ironic or at least noteworthy, I can tell you you're not alone. The markets followed up Friday's turmoil after the weekend with a 260-point drop on today, Monday, but it was down 380 at one point. Some additional perspective and more thorough analysis is warranted on these extraordinary times.

The reality is that it is going to take time for security prices to be settled in an accurate and sensible manner. For the simple reason it will take time for markets to digest all of this accurately and sensibly. The short-term uncertainty around how the European Union will behave in these settlement discussions, what the leadership change in England will look like, and what the various ramifications to do, what the ramifications will like to business confidence, etc. All of this will keep markets volatile and vulnerable for a bit. Political uncertainty is

a tricky thing for markets, and because the European Union is going to be desperate to resolve this in a way that tries to disincentivize other member nations from exiting, it will be hard for markets to discount in what it will look like. Hence the uncertainty, hence the volatility. Fortunately, we have a precedent of headline events in the geopolitical sphere that create market uncertainty. In fact, we have plenty of them. And at DividendCafe.com, we have a chart up of 12 very high-profile, significant geopolitical events, what happened in the markets the days following, and how many days it took to recover market levels after the traumatic event. The lack of objectivity in most of the analysis I've read since the referendum's passage

has been disappointing, to say the least. Many who favored the leave camp, which we certainly did, seem to be understating the reality of short-term uncertainty around all of this, and more glaring, the opponents of leave seem to be in a sort of hysterical groupthink gone awry, suggesting numerous scenarios one suspects they know are absurd on their face. We never believe pure and perfect objectivity is possible and are not even sure it's always desirable, but it is uncanny how predictable many of the large multinational financial firms are in their post-Brexit outlook. There needs to be a cogent delineation between the realities of short-term unknowns and declarations of long-term guarantees. That Brexit represents a threat to long-term global growth is an opinion, and it's not

necessarily unfair on the surface, but it's certainly not a fact. Frustration with the outcome and decision of the voters is no excuse to create a false narrative forecast. For one side to say the world will end because that side did not get what it wanted is simply immature, and it certainly is not impressive research. To be fair, I've been equally critical of such a thing when I've seen this response from people on my side of the political aisle or on an ideological issue. Things like when Barack Obama was reelected saying stocks would go down 70 percent, etc. Our job as portfolio managers is to discern what is, not what we want things to be. Filtering through the agendas of much post-Brexit commentators has not been easy,

but with all that said, consider the following points and take them with a grain of salt. First of all, the major issue I believe affecting our client portfolios in the days and weeks to come will simply be the dollar rally that has come from the Brexit vote and the dollar rally that may possibly continue for a few days or weeks. This is categorically different than being directly affected by the fundamentals of the European Union. It's expected in the wake of a declining euro and sterling pound that the dollar would rally, and it's expected that in the wake of a stronger dollar we would see weakness in oil prices, weakness in emerging

market stocks, other dollar-sensitive asset classes. We do not believe dollar-driven price movements have staying power, and we do not plan to try and trade around them. We simply would note all of the likely Brexit implications we have studied, nothing sticks out to us in our portfolio positioning as much as the immediate impact on the dollar. Before I appeared on CNBC to discuss Brexit on Friday morning, and that video is at our YouTube channel with the Bonson Group, they had a guest from the Financial Times that attempted to compare the Brexit vote to the Lehman Brothers' bankruptcy in 2008.

It brought to mind one of the pivotal tenets to understand about the financial crisis that is so often misunderstood. Lehman's bankruptcy did not cause the financial crisis. The financial crisis caused Lehman's bankruptcy. Getting cause and effect wrong can have a disastrous impact on your portfolio. In the case of Lehman, I read remarkable analysis from Louis Gov this morning who pointed out that the real paradigm shift for investors after the financial crisis moment and accompanying downfall of Bear Stearns and Lehman Brothers was the realization investors had that the smartest guys in the room, these Wall Street traders and mucky mucks, were not infallible. They did not get everything right. They were capable of doing extreme damage.

That core belief being undone represented a change in markets going forward. With Brexit, no such core belief has been unwound. In fact, the one core belief that's at the center of so much capital markets activity right now, that central banks will coordinate efforts to prop up asset prices, is highly likely to be reinforced in short order, not undermined. Speaking of media references to a Lehman moment, please note how silly the notion is from the vantage of credit markets, bank liquidity, and the financial system. When the spread and what we call the Eurobord, the LIBOR bond spread rate in the financial crisis blew out to 2% in the sovereign debt crisis in the summer of 2011, it blew out to 1%.

2011, it blew out to 1%. Currently, the spread right now sits just barely above 0%, where it's more or less been for three years. Financial markets are not indicating such a liquidity crisis as we've seen before. There's a chart to this effect at DividendCafe.com. Such central bank intervention, by the way, is likely to be what ends the dollar rally or at least keeps it in check. In other words, the dollar rallies based on this commotion, the Federal Reserve shows intention for greater assist and easy monetary policy, the dollar rally sells off. This is the pickle the central banks are in. the dollar rally sells off. This is the pickle the central banks are in. The protection of bonds in an asset-allocated portfolio has been working as interest rates have dropped ferociously, causing bond prices to rally. At press time, the 10-year treasury

yield sits below 1.47%. These fixed income protections, while boring and non-opportunistic with rates are so low, can become quite effective and defensive in times like this as far as smoothing market volatility. They also reflect a certain degree of irrationality caused by the aggressive purchases of safe haven assets, a trend that often leads to money flowing into more defensive dividend stocks as investors search for higher yield. Next point, mechanically the non-binding referendum from Brexit becomes actionable when the British government triggers Article 50 of the Lisbon Treaty, which then gives this process two years to play out or longer if needed. Already European Union officials have pleaded for a fast track from Britain and I see no early indications that the EU plans

to make this easy for Britain. The only real systemic fear I would have is if the UK and EU decided to enter the departure negotiations with a commitment towards a mutually assured destruction, the phrase I'll borrow from my friend Larry Kudlow. Suffice it to say, we think it very unlikely that either side will take a posture that assures major damage to their own side. We do not believe the EU is going to be easy to work with here, but the reality is that both sides have fair amounts of leverage that make a reasonable divorce agreement more likely than not. We're reading plenty of analysis suggesting Brexit will not even end up being consummated, that Parliament will refuse to trigger Article 50, or that the voters will pursue a re-vote. Noise about a Scottish referendum to leave the UK and stay in the EU is floating around as well.

My belief is that these discussions of buyers' remorse or political hardballing are unlikely to have much to them. But I also believe that any kind of inclination or guidance towards the UK announcing a desire for the kind of bilateral trade agreement Switzerland has, or let's say membership in the European Economic area that Norway has, these types of things would end up soothing a lot of the fears around the pending transition. That said, for those concerned that Brexit will not happen, which includes 50% of the UK voters and myself, if I had my say, or those concerned that it will happen, which would concern, if I had my say, or those concerned that it will happen, which would concern, which would involve both President Obama, candidate Hillary Clinton, a lot of the big Wall Street firms.

Well, regardless what side of the issue you're on, here's five possible deal breakers that could prevent implementation real quickly. One, the UK Parliament decides to vote against Brexit. Two, the EU makes concessions that the Prime Minister and Parliament deem sufficient. Three, a new election takes place in coming months. Four, Scotland and Northern Ireland somehow manage to block it with a complicated legal maneuver. And five, a second referendum is called and shows a different result. We don't see any of these things being very likely, but this is part of the analysis that we're doing and tracking. Next point, our concern is not with the details of how this plays out for the EU,

but rather measuring the systemic risk to U.S. equity investors, which we believe will be very low. We're maintaining a virtually 0% weighting in European equities, which has been our posture for many years due to fears of debt deflation and inadequate economic growth. We're watching UK equities where prices suggest a value, where dividend yields are actually attractive even across the entire index. But when a recessionary backdrop is there, it has to be respected. So we're approaching that moderately. The best case scenario with the remainder of the EU would be for there to be a wake-up call for fundamental reforms, but we do find that very unlikely. We also doubt that other countries fording with referendums of their own will find a lot of

traction there. We certainly see how this issue could grow in political ramifications for individual countries. How the European Commission responds to this as far as its posture with other member nations is not really our primary concern. We believe London will continue to be one of the most important cities in the world and we believe the opportunities for commerce and growth will be enhanced on the other side of this exit not suppressed. While we have no intention of rushing into a buying mode around this, the market sell-off does delay any further de-risking on our part and in fact is providing more attractive valuations for some key assets. I've never seen a time in my

career that a buying opportunity did not come out of indiscriminate selling and there's no question so far this selling has been indiscriminate. The UK is 4% of global GDP and much less than that of US GDP. The concern here is not the UK and for our clients it's not the EU. There's been a little cliche that has caught on in the press that this whole Brexit deal will not lead to hell, but we're in purgatory for now. All theological problems notwithstanding, the analogy is fair enough. There just isn't going to be clear and favorable resolution anytime soon for market participants as there are many unknowns, variables, possibilities for modification.

Returns will be muted, volatility enhanced, and on the other end of this will be great rewards to investors who stick to the disciplines and fundamentals that have driven long-term investor success for most of time. The major theme in digesting post-Brexit sentiment and activity is that uncertainty is ruling the day and will be for some time. While I join many millions of people in believing this is a positive step for the UK economy and nation, the reality, as we discussed last week, is that the passing of this referendum was a shock to markets, pollsters, and pundits alike. referendum was a shock to markets, pollsters, and pundits alike. You should be under no such shock that the response of the Bonson Group is to avoid panic, do our homework, and stay faithful to our disciplines and principles. Thank you for listening to the Dividend Cafe podcast.