Coffee Break 6/28/2016

The EU referendum in the UK, that took place last Thursday 23 June and had been weighing on market sentiment for months, has resulted in a majority for the Leave camp. As a result, PM David Cameron announced his resignation the day after the referendum. The UK and the EU will now enter a long and complex negotiation process to part ways. The initial reaction on the financial markets was a strong risk-off movement. The British pound tumbled, equity markets sold off, peripheral spreads widened and high yield was under pressure. In the meantime, the safe-haven 10-year German yield dropped significantly anchoring the interest rate in negative territory.

In this context, even though we had already implemented some cautious elements in our strategy over the past weeks, we further reduced our equity exposure, and our exposure to euro zone equities.

Our current investment strategy:

Legend
grey : no change
blue : new change

EQUITIES VERSUS BONDS

The announcement of a vote in favour of Brexit clearly has a significant negative impact on the European economy and financial markets. Therefore we have decided to reduce our equity exposure to an underweight. Also, we decided to reduce our short duration, as safe haven bonds will perform in this market context.

The investment horizon has been shortened as visibility has been reduced by the outcome in the EU referendum in the UK. A nimble approach in our investment scenario will be warranted in the coming months as Brexit raises more questions than answers. We are reassured by the hands-on approach by Central Banks. Currently, the main risks for markets include:

• Division in the UK, and even potential disintegration of the UK (as Scotland and Northern Ireland voted in favour of remaining in the EU) will add complexity to negotiations.
• Length of Brexit negotiations: it will add to uncertainty, volatility and potentially have a stronger impact on business and consumer confidence in Europe
• A potential division of the rest of the EU member countries by being too accommodative (incentive for other EU members or populist parties to ask for some renegotiation) or too firm (EU members have divergent interests) in the negotiation

Outside Europe,

• The macroeconomic news flow is in line with sluggish but positive growth. Stabilising macro indicators and the recovery in commodity prices have led to easing financial conditions compared to the start of the year.
• The bi-annual Congress testimony from Fed chair Janet Yellen has been perceived as dovish by market participants. During its last meeting on 15 June, the Fed decided to leave its main interest rate unchanged at 0.5%. Discount rate (aka primary credit rate) stays at 1%. Following the UK referendum, the market no longer expects any rate hike this year.
• Both the ECB and the BOJ have policy rates anchored in negative territory while pursuing quantitative easing and potentially stepping them up in Japan, in particular following the recent JPY appreciation in the wake of the EU referendum in the UK.
• The PBoC is set to continue its easing policy at a later stage.
• Emerging markets remain historically cheap and have been resilient in the Brexit aftermath.

REGIONAL EQUITY STRATEGY

• We maintain our underweight in UK equities. We were underweight before the referendum and will stay underweight UK for now.
• We decided to reduce our exposure to euro zone equities to an underweight.
• We have decided to implement a neutral stance on US equities, as the US market is less impacted and thus more resilient in the current market environment.
• We have decided to have a neutral stance on emerging markets equities: the short-term evolution will depend on the evolution of the USD, a more dovish Fed and the global context, we believe there is no reason to reduce exposure to the region.
• We are neutral on Japan.

BOND STRATEGY

• In the light of Brexit, we have reduced our short duration as investors are looking for safe havens.
• We continue to diversify out of low/negative yielding government bonds:
  • We are positive on credit. In the current context, we see more potential in credit than in equities.
  • We are positive on inflation-linked bonds. We view the subdued inflation expectations as a temporary phenomenon and expect consumer price inflation data to rise gradually. This implies a re-rating of inflation-protected bonds over the course of the coming quarters.
  • Our constructive view on commodity prices is reflected in our exposure on emerging market debt, both in local and in hard currency terms.

• In the US, durable goods orders fell more than anticipated in May. According to the Commerce Department total orders for long lasting manufactured goods fell by 2.2% and core durable orders, which exclude transportation, dropped by 0.3%.
• The number of American filing for unemployment benefits fell near a 43-year low as initial jobless claims dropped to 259.000, the largest decline since February. This will increase the Fed's confidence in a pick-up of the job growth.
• In Europe, economic activity grew at a slower pace than expected this month. A surprising bounce in manufacturing could not offset the slowdown in services. The Composite PMI fell to a 17-month of 52.8, though remaining firmly above 50.
• In Germany, investor sentiment improved in June, confirming the economic resilience as the ZEW-index came in at 19.2. 

Negative week for commodities last week.

• Crude oil prices lost about 5.5% last week due to the USD rally which occurred immediately after the release of the result of the UK referendum.
• US grain prices were also severely impacted by the UK referendum. The potential for US crops to grow pricier added to existing concerns as the US farm belt has been favoured by rain and cooler temperatures.
• Corn prices went down by about 8.8%, wheat and soybean by about 4.5%; while coffee, sugar and cotton lost close to 3%.
• Gold was also impacted by the "Brexit" vote, with an increase of 2%, as investors favoured safe haven investments. 

EUROPE

Negative performance for European equities with the Stoxx 600 closing at 315 down by 6.57% for the week.

• European markets were hit hard last week following UK voters’ decision to leave the European Union.
• London’s FTSE 100 tumbled more than 8% in early Friday morning trading, before recovering and ending the day down by 3.15%.
• Germany’s DAX fell the most since the 2008 global financial crisis and lost 6.82%.
• Britain’s big banks (Barclays, Lloyds and the Royal Bank of Scotland) were some of the biggest decliners as investors were concerned about their future earnings potential.
• Italian banks were also in free fall and Spanish banks with significant exposure to the UK pummelled.
• At a sector level, Health Care, Food & Beverage and Chemicals ranked better than the Stoxx 600 (-0.36%, -1.17% and -3.53% respectively) while Insurance (-11.18%), Travel & Leisure (-11.30%) and Branks (-15.43%) were clearly underperforming.

US

Negative performance for US equities with the S&P 500 closing at 2037 down by 1.63% for the week.

• UK’s vote to leave the European Union dragged down US stocks along with other global markets.
• Last week decline brought the S&P 500, the DJIA and the small-cap Russell 2000 Index into negative territory for the YTD.
• US equities reached their highs for the week on Thursday, when it was understood that the UK would remain in the EU. However, after it became clear that the vote had gone the other way, all the main indexed plummeted at the opening of trading on Friday.
• Last week’s US economic data were mixed with a lack of business investment and concerns over productivity. But published figures also showed a recovery in export orders.
• At a sector level, Telecoms, Utilities and Energy outperformed the S&P 500 (1.36%, -0.27% and -0.62% respectively) while Industrials (-2.40%), Financials (-2.44%) and Materials (-2.56%) were underperforming.

EMERGING MARKETS

Nearly flat performance for Emerging markets equities down by -0.04% for the week.

• The UK's vote to leave the EU triggered small losses in Emerging markets stocks as a result of risk aversion and evolution of commodity prices.
• Asian and LatAm markets held up better than Emerging Europe.
• South Africa, due to its trade connections with the United Kingdom, was particularly hard it.
• At a sector level, Consumer Discretionary, Energy and Financials fared better than the index (0.56%, 0.45% and 0.32% respectively) while, Industrials (-0.54%), Materials (-0.71%) and Telecom Services (-0.76%) were all below the benchmark. 

RATES

Global sovereign markets posted very strong returns last week, as the EU referendum in the UK sent a shockwave across risky markets, prompting G10 rates to decrease dramatically.

• Core euro zone indices posted the highest returns, as Germany's 10Y rate dropped below zero, hitting an all-time low of -0.17% intraday, before settling down to -0.05%.
• Rates from peripheral countries increased in the context of risk-aversion. As a consequence, the spread between Italian and German 10Y yields jumped to 160bps (from 140bps at the beginning of the week).
• Traditional safe haven assets delivered strong performances (US Treasuries and Japanese Government Bonds. 

CREDIT

Following the UK's decision to leave the EU, concerns about global growth, political uncertainties and its consequences caused a significant correction for risky assets, and in particular the credit markets.

• On average, spreads of IG credit widened by 12bp after the results of the vote.
• The banking sector was the most affected with Senior UK banks widened by 30-50bp and Subordinated by 75-100bp.
• Core Non-financials were the most resilient assets, sustained by an ECB which increased its assets purchases during the week.
• In this context, we prefer to stay cautious: our credit funds are close to neutral in terms of global credit risk exposure and are underweight on UK assets. 

FOREX

Not surprisingly, the GBP suffered the most last week amongst G10 currencies, losing close to 5% vs. the USD

• At the higher end of weekly returns, the JPY was chased by investors for its safe haven status and gained 1.90% vs. the USD.
• The CHF did not performed as strongly as expected as the SNB intervened in FX markets to tame any strong appreciation of the Swiss currency.
• The EUR was also hit by the "Brexit" vote, losing 1.42% against the USD.

WEEKLY MARKET OVERVIEW

UPCOMING FACTS AND FIGURES