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Why the UK Cannot Leave the EU. Say No To Brexit. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 22 June 2016 03:27

We can't leave the EU, not yet. The EU remains a flawed union but not a broken one, and quite clearly, the rationale for joining it in the first place was to ensure it was a failed union. As the Cabinet Secretary has said before, we've fought with the French against the Germans, the Germans against the French, the French and the Germans against the Russians and with the Germans, French and Spanish against everybody else... It might have been a roaring success. Well, not quite. The union still stands and the job is not yet done.

To really undermine the union would involve joining the currency union but the costs would be too high, so the next best is to remain in the EU and prise it apart with British exceptionalism. In this respect, the task is yet unfinished. But, we are getting closer. There is certainly more fighting today, unfortunately it’s the Germans against the Germans, the French against the French and the Spanish against the Spanish. And most unfortunately we've got Britons fighting Britons, specifically the Tories against the Tories, Labour against Labour and the UKIP against any form of sense. The only country which isn't fighting itself is Russia. They've got their hands full fighting anti-money laundering authorities everywhere just to find a suitable custodian for their assets.

So job not done, please Remain where you are and resume fighting for what you believe in.

Last Updated on Wednesday, 22 June 2016 05:28
Asset Allocation To Active Managers PDF Print E-mail
Written by Burnham Banks   
Thursday, 16 June 2016 00:29

Asset Allocation to Active Managers.






Last Updated on Thursday, 16 June 2016 00:30
Brexit. Inaccurate Polls. Long Term Consequences. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 14 June 2016 00:26

The latest Yougov poll on the EU referendum has the 42% voting to Remain, 43% voting to Leave and 11% undecided. The result in any case will be unpredictable because the voting intentions are not driven by commercial interests but by political, social and emotional ones, and the material consequences of leaving the EU are to a great extent, unknown. Bookmakers odds paint a different picture with odds of exit at mid-30s percent. One explanation is that the polls reflect what people want to do, whereas the odds reflect what people realistically intend to do. Opinion polls have become more inconsistent as negative voting has become prevalent. If this thesis is true then the UK will vote to remain in the EU.

Depending on how acute the fear of Brexit becomes before June 23 and the extent of damage in the markets and sterling, the rebound could be significant. The bond markets have been fairly resilient even controlling for the compensating impact of duration. Last week, Euro investment grade outperformed euro sovereigns although investment grade did also outperform high yield. The commencement of the ECB’s corporate securities purchase program had some impact on the euro IG market. The euro leveraged loan market lagged with a flat performance. As we approach June 23, don’t expect credit markets to remain resolute. They will likely also experience volatility.

Notwithstanding the bookmakers’ odds favoring Remain, the situation is very volatile and a geopolitical or security event could easily overturn the odds in an instant. Even without an event, the words and actions of the players in the theatre could spark market volatility as well.

The consequences of Brexit are difficult to quantify. The UK is the EU’s single largest destination for exports representing 17% of the total while the EU accounts for 45% of UK exports. The UK runs a goods trade deficit (-66 billion GBP) against the EU but a trade surplus (+10 billion GBP) in services. For both sides, the rationale for a trade agreement is therefore strong, however, a liberal agreement on services may be more difficult to obtain. The impact on sovereignty will depend on the UK’s intentions regarding maintaining trade access and could involve retaining compliance with the majority of EU legislation while losing the ability to influence its formulation. Trade access would also mean continuing to contribute to the EU budget. Broadly, the UK can leave the EU for reasons of budget contributions, sovereignty, immigration and benefits arbitrage, but it would have to forego trade access. To obtain trade access it would have to reinstate contributions to the budget, compliance with EU legislation, open its borders and provide access to benefits. This would be analogous to a switch from a contractual telephony plan to a pay-as-you-go plan. Complete replication will neither be desired nor achievable. The EU will want to discourage other members of the EU from leaving and would have to impose costs upon the UK to set an example.

Any analysis will be inadequate because only the instantaneous effects are the least bit predictable. The impact on sovereignty, trade, immigration and politics will vary as each agent’s behavior evolves in reaction to the actions of other agents. In the best case, one could hope that the UK economy is sufficiently flexible that the new degrees of freedom are used wisely and growth is enhanced. In a more sober scenario, the event of Brexit is a Y2K event, a non-event, where an omnibus relationship is replaced with a series of specific ones which largely replicate the pre Brexit status quo. In the worst case, the UK either cannot or will not negotiate to reinstate trade access and goes down the path of trade war to the detriment of both the UK and the EU. Given the already fragile economic condition of Europe, this is a scenario they can ill afford and the region plunges into a protracted recession. In a scenario which is hard to classify as good or bad, the UK example emboldens other members to leave the EU which ultimately threatens the Eurozone and the single currency is abandoned.

The reaction functions of players in this game are non-linear. But the range of our vision allows us only to extrapolate.

It is unlikely that the UK will vote to leave the European Union.

If it does, the consequences will be short term instability and long term gain on both sides simply based on the adaptability and resourcefulness of humans.

Last Updated on Wednesday, 15 June 2016 08:06
Investment Outlook June 2016. Ahead ot Brexit. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 15 June 2016 08:03

China growth is also stabilizing but this has a cost in credit creation. The natural growth rate is slower in the new regime but the government cannot allow the economy to function there. As a result it is overstimulating the economy with side effects in commodities and real estate. These sectors will be very sensitive to Chinese policy and timing these markets will be quite difficult.

Japan is back in a difficult position. The sales tax has been postponed but this will not be sufficient. An outsized fiscal package is likely but this will only worsen the balance sheet. The BoJ will be drafted into more debt monetization. If the inflation target is to be achieved, another round of concerted fiscal and monetary policy will be needed.

The US economy is fundamentally on sound footing and we expect a pick-up in growth as spreads have stabilized. We also note that the manufacturing sector appears to have completed its pivot to a domestic audience. The poor employment number in May was an indication of a skills mismatch and not weakness in the economy. Wages are holding up, quits rates have recovered, initial claims have been subdued. Manufacturing PMI has been over 50 for 3 months now.

Oil prices have done very well this year. Oversupply peaked in January and has receded a little. At these levels we are seeing now a 3rd week of increasing rig counts. Oil prices should not rise any more from here. At these levels, however, HY defaults will still rise although the headline correlation will be reduced.

FOMC: Fed could not have moved even if it wanted to. The Fed’s control is the Fed funds rate but the real economy funds itself at market rates. Sell offs lead to spread widening and de facto tightening. Is a rate hike on July 27? It all depends on the market price of credit. If markets are well behaved, the Fed can act, if they are not, then the Fed cannot act.

The EU referendum is on the agenda. The polls have Leave in the lead by 43 to 42. The bookmakers have Remain in the lead by 65 to 35. We believe the bookmakers. Polls pick up what people want to do but bookmakers pick up what people intend to do. Negative voting has been prevalent in recent elections which have led to inaccurate polls.

Europe also looks to have been stabilized by the ECB but growth is fragile. A Brexit is going to hurt the EU. The UK is 17% of EU exports but the force of sentiment will have more immediate impact and could derail the recovery. We expect the impact on Europe could be greater than the impact on the UK. The UK economy is relatively strong compared with the EU and better able to absorb the shock of disengagement. If sterling weakens more, it could improve the UK’s competitiveness. If the euro is also weak, and there are reasons to expect this, Europe may benefit also. This might achieve what QE could not, which was to weaken the euro.

Peripheral spreads will widen on Brexit but France and Germany and the ECB will most definitely move to strengthen the union. This would see peripheral spreads snap back quickly.

Liquidity is low in the summer and we have a number of events including EU referendum, Spanish elections, Republican and Democratic conventions, Japan upper house election, and the run up to the US presidential election.

Equity valuations are high. Apart from the US, fundamentals are still fragile. Credit spreads are tight. Sovereign yields are too low. The margin for error is very small. There will be some who hope the financial press can keep the Brexit flame alive, and even hope for Brexit, to bring markets lower. At current prices there are few opportunities and one almost needs to shake the tree.

Is Brexit a globally systemic event?

  • How immediate is the problem? 2 year holiday.
  • Contagion risk? European problem. Could escalate. EU exports to UK 17%. UK exports to EU, 45%. Exports to ROTW should not be affected. UK is 2.36% of world GDP. EU ex UK is 13% of world GDP. UK is not part of Eurozone. Not part of TARGET2.
  • Sentiment risk? High in the short term.

For those with a high cash holding it is time to add some risk, pre EU referendum.

Last Updated on Wednesday, 15 June 2016 08:07
Market Outlook 2016. Where To Invest in 2016/2017. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 08 June 2016 00:50

It is now difficult to see more than 10 seconds into the future. What was chosen for a laugh as a blog title has become a reality. Central banks have led the markets if not the economy for the last 8 years out of crisis and are now losing some credibility and control. A quick survey finds weak but positive growth across most countries with the exception of Brazil and Russia in 2016, and positive growth across all countries in 2017. It also finds inflation mercifully low, and positive, even in Japan and the Eurozone. This does not appear to be a dire environment. However, aggregate data hide less tractable problems. If the averages are poor and the inequality is acutely high, it means that the majority of the population are experiencing declining wealth. Mercifully, inflation has been low.

It is always a difficult time to invest. In the 90s we fretted about inflation which in the end failed to materialize. We inflated a tech boom bubble which burst. We inflated a housing bubble which burst. And since then we’ve been led by the nose by central banks cleaning up the debris of the last bust while trying to strengthen the financial system which proved not so robust and simultaneously trying to spur economic growth which sputtered in no small part because of those very efforts at financial market reform.

The US economy is out of the woods and on a stable path of positive if rather tepid growth. The European economy is not far behind. The inefficiencies of the Euro are something they will live with regardless but so much liquidity is bound to spur some growth. China was actually first to lead with unconventional policy. It saw external demand shut down in 2008 and continue to fade as countries engaged in trade war. China is arguably ahead of the cycle in terms of policy, priming the pump quickly, smoothing the downturn, then tightening prematurely, hopefully not a lesson for the Fed, and finding itself needing to turn on the taps again. Japan is perhaps way ahead of everyone else. Demographically, Japan is the future. We can only hope that it is not also the future in terms of economics and policy.

Policy has targeted an arbitrary rate of growth and in doing so introduced more imbalances which drive delayed oscillations in market prices. At the micro level we already observe that asset prices can deviate from fundamental value for longer and gyrate more substantially as they converge to intrinsic value. Long duration assets are all the more risky in that there is no deadline for convergence. Finite and shorter maturity assets are not immune to volatility. Policy, sentiment and capital flows are the prime determinants of price discovery. Markets fail to bring convergence to intrinsic value quickly and efficiently.

There are several reasons for this. In the past, relative prices were brought into equilibrium or no-arbitrage pricing by traders or groups of traders who traded across capital structures. Most of this capital took the form of bank proprietary trading desks. With Basel III, Dodd-Frank and the Volcker Rule, the capital dedicated to these activities has shriveled. Some of these traders have sought new homes in hedge funds. However, the scale of capital in hedge funds pale in comparison with the practically bottomless pits of capital commanded by prop desks in the past.

In the search for yield, retail investors, through their regulated and sanitized vehicles like mutual funds and ETFs have ventured into markets normally traded by professional investors. The herd mentality and the artificial liquidity created by retail capital has led to more momentum driven markets where undervaluation soon becomes overvaluation and overvaluation becomes undervaluation in a cyclical and volatile fashion. Prop traders accustomed to leveraging small, predictable deviations now face large, unpredictable deviations, and in their hedge fund formats, face prime brokers who cannot extend the scale of leverage they are accustomed too, or the valuation forbearance of the investment banks of old. Therefore, they struggle. This is the new market, at least for now.

One could play the long game, identify good businesses and invest for the long term. To do this, one needs not only to be right, but one needs stability of capital and the faith of investors. With the current uncertainty, investor loyalty is understandably in short supply. Uncertainty is high. When economic growth is low, small deviations can lead to negative readings. The acute inequality of wealth is slowly translating into the feeling of injustice, and society seems heavy with social tension. Between political factions there is more civil war than inter party conflict. Policy has been deployed bearing such low marginal fruit that it has taken extreme efforts to have any effect. The risks of unforeseen side effects proportionate to the scale of the effort, not the effect, are high.

The inescapable reality is that markets have become more volatile and fickle. The patient investor can take advantage of this volatility but this can often be a test of stoic patience. Markets like this also require the investor to be more informed, even if they are outsourcing their investing decisions lest they make mistakes in their capital allocation plans. For investors who need to be invested many opportunities remain, and some very good ones at that. Investors should be careful not to overreach in their thirst for yield. However, there are areas of the market which remain beyond the reach of retail capital and other hot money and where price discovery remains linked to fundamentals. Some of these markets are the way they are because of legacy issues from the 2008 financial crisis, some even performed well through those periods but through guilt by association will not be revisited even by some institutional investors. Under-owned, under-researched, misunderstood assets represent good opportunities. But even here, markets may not be sufficient to bring price discovery; patience, and duration matching of capital, is necessary.

Last Updated on Wednesday, 08 June 2016 00:52
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