Brexit and Beyond

Friday, September 9th, 2016

Following the surprising British vote on June 23 to leave the European Union, alarm bells sounded worldwide with dire warnings from investment experts such as George Soros and political pundits such as George Will saying that the world as we knew it was coming to an end. Yet after a short global market selloff the dire assessments were quickly scaled back and rephrased to a “let’s wait and see” response. More recently the Brexit trauma rumblings have been replaced with predictions about new market highs. None of this should be too surprising since we heard similar alarm bells from after the Russian debt meltdown in 1998, the 2001 Internet bubble, the 2014 Greek debt crisis and most recently the Chinese currency devaluation in 2015. Also we should not be too surprised about the one group of clear early winners on the vote to leave the EU: British shrinks. According to an article in The Guardian, a London psychologist reported that her appointment calendar, previously languishing had suddenly ratcheted upward and nearly every session was about how to deal with “The Vote.” There is instability and anxiety,” said the London psychologist, “but alongside of that there is “some exhilaration, as many are for the first time caught up in the fate of their country.” One client after seeing her therapist tweeted that she planned to send the invoice to exiting PM David Cameron, who probably did not head directly to his shrink: he was caught unawares on a reporter’s microphone happily humming as he cleaned out his office and left 10 Downing Street. Far too much ink was spilled on what tune he might have been humming or why, and perhaps that is one of the better commentaries on the vote. All of the hue and cry over Brexit and previous “this time it’s different” pronouncements brings to mind Mark Twain’s comment about Richard Wagner’s music: “You know, it’s really not as bad as it sounds.”

SHOULD WE SING “AULD LANG SYNE” TO BONDS?

One of the most respected and successful fixed income managers of the past decade, Jeff Gundlach of Double Line Capital had some noteworthy commentary on the current state of the bond market:

“There is something of a mass psychosis going on related to the so-called starvation for yield.”

As of June 30, 2016, Mr. Gundlach’s flagship fund with $61 billion in assets held just 3.4% of its assets in US Treasury Bonds, which is a new low for actively managed bond funds. In the past 30 years the yield on the 10-year Treasury has dropped from 7.5% to 1.5%. Most of that decline has occurred in the past 10 years: on June 30, 2006 the 10 year Treasury yield stood at 5.2% and now is 1.5%. A staple of moderate allocation investing for both institutional and retail investors has been the classic 60/40 equity-to-fixed-income split. The economist and investment manager most closely associated with this idea, Peter Bernstein, said in a white paper written in 2002 that the allocation should be permanent given the unpredictability of both the markets and investor psychology. For Bernstein and others the 60/40 balance was as much a philosophical stance as well as a financial credo and reflected the thinking of Warren Buffet’s mentor Benjamin Graham when he noted: “successful investment management is about the management of risks rather than returns.” This balanced account approach has done very well in the 14 years since the Bernstein article because of outsized returns from the bond market following the financial meltdown of 2008. But getting a big return from bonds was not the thinking behind the idea. Bernstein argued that even though the 60/40 balanced portfolio trailed a more aggressive allocation it was still the preferred path since it took emotional responses to market swings out of the equation. Many billions of dollars worldwide are still invested along those guidelines, but is the classic 60/40-fund allocation still a viable strategy? The party if not already over may be ending. In Germany a 10-year Bund, or German Treasury came to market in July with a negative yield. How long the buyers of these bonds are willing to pay the German government for the privilege of lending it money remains to be seen. This event is more noteworthy than Mr. Cameron humming as he left the Prime Minister’s office yet there are no reports about German psycho-therapists having an upsurge in business on account of “The Bond.” Global markets have not seen the negative yield on German Treasury bond as the end-of-the world as we know it. In fact, many commentators currently perceive it as a simulative plus, although there are dissenters. Bill Gross, formerly the head of PIMCO, told CNBC: “a liability is a liability and contrary to capitalism as we know it. “ Yet despite the attempted “QE Hail-Mary’s” by the central banks, capitalism, as we know it seems to be bumping along reasonably well. The US economy keeps growing steadily, even at plough-horse rates, and the crashing bond yields tilt asset allocation models in favor of equities, especially high quality dividend paying stocks, and conservative yield enhancing option strategies. For as Mr. Gundlach aptly noted, investors, crazed or not, are going to have to find investment yield somewhere: 80/20 funds here we come!

GLOBILIZATION AND ITS DISCONTENTS

Something else that is also not as bad as it currently sounds is “globalization.” After all if both Donald Trump and Bernie Saunders are in agreement on something being a disaster, then it is probably not all that bad and certainly deserves a second look. Long before controversial trade agreements such as NAFTA, and Trans-Pac, globalization played a large part in building the US and world economies. In the late 19th century US railroads would not have been funded without the capital from European investors. Yet the alarm bells we hear now were sounded then because American First adherents expressed concern about Wall Street bankers such as JP Morgan and Jacob Schiff being controlled by the Rothschild’s. Schiff quietly ignored the nativist anti-Semitic critics and single-handedly restructured the bankrupt Union Pacific Railroad with capital from British and German banks. The largest rail transport company in the US would probably not be in existence today but for Schiff’s brilliant global deal. For what it is worth, Schiff is still blamed (or credited) by conspiracy theorists for infiltrating the Federal Reserve and financing the Russian Revolution with Rothschild money. JP Morgan, sometimes Schiff’s ally but far more often his competitor in financing railroads and companies such as Westinghouse and US Steel, had no problem aggressively bashing those who questioned his dealings, famously shouting at a New York reporter: “I owe the public nothing!”

So we have seen discontent about so-called rigged global financial alliances before and we will see it again. The Brexit vote while unexpected will likely be a manageable protest against immigration. While political and financial talking heads continue to scurry and comment, many companies and entrepreneurs are already lining up to make money from the disruption. Some early winners have been British manufacturers with exports rising by double digits since the vote. The service sector especially in London is still doing very well and the feared mass exit of financial companies from the City of London has not transpired. Donald Trump who has done pretty well from globalization with off-the-books golf course deals (some suggesting that he may not want to show his tax returns for that reason), continues to rail at immigrants and beneficial trade agreements. The British, European and American nativists all send messages on IPhones and tweets via their laptops, go home and watch the Olympics on LED flat screen TV’s without seeming to consider that if they had their way none of these devices would be available or affordable. To put this in very simple terms for Trump, Bernie, Libertarian Candidate Gary Johnson (who admitted he needs a geography lesson), globalization in all areas of investment and trade has been and will be a major and very beneficial component of the US economy for all income groups. A telling comment was made last year by John Bogle, the founder of Vanguard Funds, who was asked about his recommended allocation to international equities: “there’s no need to own any since US companies do so much of their business globally.” This very straightforward answer would be music to the ears of the early global investors in US companies.

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