Post-Brexit, are markets revealing something about the fundamentals that isn’t broadly appreciated by analysts?
Going into the UK’s referendum to leave the European Union last month, the prevailing view was that the Stay camp would win by a narrow margin. Instead, the Leave camp prevailed by a narrow margin, surprising a significant majority of market participants and commentators.
Shortly before the vote, I stated that the initial market reaction would likely be negative; but I also said that it would be short-lived and we would probably recover any losses relatively quickly. Part of this view was simply the observation that this event was very much a “known unknown” that had been discounted to some degree. Furthermore, there had been a significant rise in hedging activity leading into the event, with a spike in the cost of such hedges as measured by implied option volatility.
Fast forward four weeks and the reaction has been almost exactly as predicted last month.
A Surprising Recovery
Following the vote, global equity markets fell approximately 7% and to date, they have recovered all of their post-Brexit losses; even European equity markets have recouped 100%. Perhaps the most surprising result has been the UK equity market, which, after the vote, dropped the least and rebounded the most; it’s up close to 10% (in pounds) for the year to date, more than any other major developed equity market. This is a perfect example of why it’s so important to understand what is already priced into the markets before such known events and why I thought the response to Brexit could ultimately be positive no matter what the outcome.
Now, there is a case to be made that bearish investor positioning has been completely reversed and that equity markets and other assets that could be negatively affected by a Brexit have overshot to the upside. However, we don’t think so; in fact, we believe markets may finally be focusing on the constructive fundamental backdrop we have been trying to talk about over the seemingly never-ending political and geopolitical noise.
A Supportive Macro Picture
First, there is growing evidence that the recession in the energy, industrial and manufacturing complex ended in the first quarter. Second, thanks to mini-crises in European and Japanese banks, the Brexit, the US presidential race and uncertainty around China, global central bankers are on high alert to make sure they don’t stop the stimulus too soon.
In fact, the affirmative Brexit vote may lead to increased fiscal stimulus around the world, which could be the ingredient whose absence since the financial crisis has led to such a disappointing recovery.
This is what we think the markets may be discounting and why they have responded so strongly after what was seemingly a negative outcome. In many ways, the Brexit vote has simply accelerated our prior view that growing populism would force politicians to address the concerns about the uneven recovery, income inequality and the pressure of immigration and globalization on wages in many developed countries.
Still, there are many who remain quite skeptical of the recent all-time highs for US stocks, suggesting the fundamentals don’t warrant such a move. In fact, individual investors’ bullishness remains quite low considering where the S&P 500 is trading. In the chart below, we can see that individuals have become more bullish since the lows around the Brexit vote. Even so, we are still in neutral territory on sentiment and we are coming off one of the most bearish two-year periods in history.
*10 Week Average
Furthermore, the next chart shows that money flows to equity mutual funds and exchange traded funds have rarely, if ever, been more persistently negative than they have been during the past two years. While I just acknowledged that the market can always surprise us, one thing my 25 years of experience has taught me is that this is not how bull markets end.
Could the markets’ defiance be telling us something about the fundamentals not yet appreciated by analysts more broadly?
We think they might and, in addition to the higher prices, the incredible thrust in equity market breadth tells us not to ignore it. Breadth is a measure of how many of the stocks within a major market are participating in a move higher or lower. When breadth is confirming the directional move, it should generally be more trusted. We have observed many times that market breadth has been improving during the US stock market rally that began in February. That’s a good thing. Interestingly, the breadth since the Brexit vote has actually accelerated in a way that rarely occurs.
This is important for several reasons. First, according to Nautilus Research Partners, the breadth thrust of the past few weeks has only happened 12 times since 1989 and has always been very positive for S&P 500 returns six-to-12 months forward.
Second, the thrust occurred just as the S&P 500 broke out of a two-year trading range, which is another positive technical signal. Ignoring these signs would be foolish. Therefore, we at the Global Investment Committee are incrementally more bullish on U.S. equities even though they are trading at all-time highs. These power technical signals give us more confidence in our constructive fundamental view for higher earnings and continued low interest rates, which together argue for higher valuations.
In other words, we think the market’s upward move is indeed a breakout and not a fakeout.