[3 min read, open as pdf]
​

• Negative Interest Rate Policy (“NIRP”) is a “last resort” policy tool
• The UK is getting ready for “NIRP”
• The hunt for yield and alternatives to cash

 
A “last resort” policy tool
Zero & Negative Interest Rate Policy are Non-Traditional forms of Monetary Policy is a way of Central banks creating a disincentive for banks to hoard capital and get money flowing.
Zero Interest Rate Policy (ZIRP) is when Central Banks set their “policy rate” (a target short-term interest rate such as the Fed Funds rate of the Bank of England Base Rate) at, or close to, zero.  ZIRP was initiated by Japan in 1999 to combat deflation and stimulate economic recovery after two decades of weak economic growth.
Negative Interest Rate Policy (NIRP) is when Central Banks set their policy rate below zero.  Japan, Euro Area, Denmark, Sweden are currently using a NIRP. US & UK are currently using a ZIRP, and are considering a NIRP.
​
Fig.1. Advanced economy policy rates

Whilst bond prices may imply negative real yield, or negative nominal yields, a NIRP impacts the rates at which the Central Bank interact with the wholesale banking system and is intended to stimulate economic activity by disincentivising banks to hold cash and get money moving.  A NIRP could translate to negative wholesale rates between banks, and negative interest rates on large cash deposits, but not necessarily retail lending rates (e.g. mortgages).

Ready, steady, NIRP
Negative Interest Rates were used in the 1970s by Switzerland as an intervention to dampen currency appreciation.  .  It was the subject of academic studies and was seen as a last resort Non-Traditional Monetary policy during the Financial Crisis of 2008 and during the COVID crisis of 2020. Sweden adopted NIRP in 2009, Denmark in 2012, and Japan & Eurozone in 2014.  The Fed started looking closely at NIRP in 2016.

According Bank of England MPC minutes of 3rd March 2021, wholesale markets are generally prepared for negative interest rates as have already been operating in a negative yield environment.  By contrast, retail banks may need more time to prepare for negative interest rates to consider aspect such as variable mortgage rates.

There are arguments for and against NIRP.  The main argument for is that NIRP is stimulatory.  The main argument against is that NIRP failed to address stagnation and deflation in Japan and can create a “liquidity trap” where corporates hoard capital rather than spend and invest.

The hunt for yield
With negative interest rates, there will be an even greater hunt for yield.    We look at the some of the options that advisers might be invited to consider.

• Foreign Exchange: This is what drove many Japanese retail investors to open savings accounts in foreign currencies that – despite the exchange rate risk – paid a greater interest rate.
• Structured Retail Products may offer high headline yields, these typically involve a complex return pay-off or conditionality linked to an index level such as the FTSE 100.  Return and risk cannot be created or destroyed.  Structured Products simply re-distribute the pay-offs between issuer and investor and – in aggregate – represent market returns less product costs and commissions.  We do not consider these as appropriate alternatives to Cash in a NIRP environment, or at all.
• Mini-Bonds that offer too-good-to-be-true interest rates that lure investors in to speculative investment schemes have, thankfully, been banned for promotion to retail investors.
• Up-risking: Alternative yield options necessarily require a modest “up-risking” relative to the zero-volatility and guaranteed (if paltry) return on cash deposits.  This up-risking could include money market funds (which will also come under interest rate pressure), longer dated bonds, and ultimately equities.

Getting the balance right between additional non-negative income yield and additional downside risk will be key for investors and their advisers when preparing for and reacting to a NIRP environment.

[3 min read, pdf version]
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• We differentiate between moderate and high turnover strategies
• Moderate turnover strategies: markets continue to look overbought
• This drives preference for lower relative position in risk-assets

 
Moderate turnover strategies: Monthly Elson Market Indicator
The Monthly EMI ended January 2021 at 62.37 vs 63.12 at end December 2020.
For moderate turnover strategies, equity markets continue to look overbought.
This drives a preference for lower relative position in risk assets.
The Monthly EMI remains above the threshold (60) for a move to a Neutral position in risk assets.
Momentum in the VIX Index increased from 50.9 to 54.4, whilst in absolute terms, the VIX Index closed the month at 33.1, compared to 22.8 at previous month end.

High turnover strategies: Weekly Elston Market Indicator
Over the last 4 weeks, the Weekly EMI declined from 63.87 to 59.35, as at last Friday close, falling below the 60 threshold.
Momentum in the VIX Index increased from 48.56 to 54.35 over the last 4 weeks.

[3 min read, open as pdf]

• Growth shock is short and sharp, for now
• Even lower for even longer interest rates
• Recovery extended, but vigilance required

 
Growth shock is short and sharp
The medium-term outlook for growth points more to a “short sharp shock” rather than a protracted downturn that followed the Global Financial Crisis.  However vigilance around economic growth, and ongoing dependency on vaccine rollout, fiscal and monetary policy support remains key.

Even lower for even longer interest rates
Even lower for even longer interest rates underpins an accommodative strategy to support recovery: but also has created frothiness in some asset classes.

Low nominal and negative real yields is forcing investors into refocusing income exposures, but should not lose sight of quality.

Inflation in a bottle: for now
Inflation caught between growths scare on the downside and supportive policy on the upside.  Should inflation outlook increase, nominal bond yields will be under greater pressure and inflation-protective asset class – such as equities, gold infrastructure, and inflation-linked bonds can provide a partial hedge.

Trade deal with EU should reduce GBP/USD volatility
The 11th hour trade deal concluded in December between the UK and the EU should dampen the polarised behaviour of GBP exchange rate, with scope for moderate appreciation, absent a more severe UK growth shock.

Market Indicators: recovery extended
Market indicators suggest equities are heading into overbought territory and whilst supported by low rates and bottled inflation, are looking more vulnerable to any deterioration in outlook.  Incorporating risk-based diversification that adapts to changing asset class correlations can provide ballast in this respect.

[2 min read, open as pdf]

• Momentum has been the best performing factor
• Can factors get crowded, but can they be timed?
• Will we see a persistent rotation to value?

 
A Factor-based approach to investing
Factor-based investing means choosing securities for an inclusion in an index based on what characteristics or factors drive their risk-return behaviour, rather than a particular geography or sector.
Just like food can be categorised simply by ingredients, it can also be analysed more scientifically by nutrients.  Factors are like the nutrients in an investment portfolio.
​
What are the main factors?
There is a realm of academic and empirical study behind the key investment factors, but they can be summarised as follows
The different factors can be summarised as follows:

• Size: smaller capitalisation companies
• Momentum: companies with upward price trend
• Quality: companies with strong and stable earnings
• Value: companies that are undervalued relative to their fundamentals
• Min Volatility: companies with lower volatility performance characteristics

 
Which has been the strongest performing factor?
Momentum has been the best performing factor over the last 5 years.  Value has been the worst performing factor.
 
Fig.1. World equity factor performance

Source: Elston research, Bloomberg data

A crowded trade?
Data points to Momentum being a “crowded trade”, because of the number of people oerweighting stocks with momentum characteristics.  This level of crowdedness can be an indicator of potential drawdowns to come.
​
Fig.2. Momentum Factor is looking increasingly crowded

Source: MSCI Factor Crowding Model

The best time to buy into a Momentum strategy has been when it is uncrowded – like in 2001 and 2009, which is also true of markets more generally.  MSCI’s research suggests that with crowding scores greater than 1 were historically more likely to experience significant drawdowns in performance over subsequent months than factors with lower crowding scores.
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Fig.3. Factors with higher crowding score can be an indicator of greater potential drawdowns, relative to less crowded factors

Source: MSCI Factor Crowding Model

Rotation to Value
The value-based approach to investing has delivered lack lustre performance in recent times, hence strategists’ calls that there may be a potential “rotation” into Value-oriented strategies in coming months as the post-COVID world normalises.  But can factors be timed?

Marketing timing, factor timing?
Market timing is notoriously difficult.  Factor timing is no different.  To get round this, a lot of fund providers have offered multi-factor strategies, which allocate to factors either statically or dynamically.  Whilst convenient as a catch-all solution, unless factor exposures are dynamically and actively managed, the exposure to all factors in aggregate will be similar to overall market exposure.  This has led to a loss of confidence and conviction in statically weighted multi-factor funds.

Summary
Factors help break down and isolate the core drivers of risk and return.

• Factor investing looks at the “nutrients” of investment
• Static “catch-all” approach to multi-factor investing has clear constraints, so a more dynamic approach makes sense
• Factors can get crowded, but factor allocation is hard to time

 
For more on Factor investing, see
https://www.elstonsolutions.co.uk/insights/category/factor-investing  
​https://www.msci.com/factor-investing 

A local problem?
​In January, when the Coronavirus story broke in China, the global response was that this was a localised issue.

Like other viral outbreaks such as SARS (2003) and H1N1 (2009), the issue look localised to China and Asian Emerging Markets.

Going global
In February, as the virus spread aggressively in South Korea and Italy, markets woke up to the fact that this was a global issue.  The questions being how far would it spread; how fast would it spread; and how long would it last?

All of these questions were to ascertain how materially the outbreak would impact global growth, as demand falls, businesses' cash flow struggles and supply chains are disrupted.

A false sense of security
What was deceptive is that the time from the first infection in a country to the virus "j-curving" has been quite long 20-30 days.  This gave Europeans a false sense of security that the outbreak was containtable.

The J-Curve
The chart below shows the J-curve as to how long it has taken for some key countries to reach 1,000 cases.  The reality is that once it gets going, containment is difficult without some of the extreme measures introduced quite promptly in Wuhan (wide area quarantines or "lockdowns"), and more recently in Italy.

• Conservatives win majority on mandate to Get Brexit Done
• Breakthrough in traditional Labour heartlands
• Labour’s Corbyn under pressure to step down and Liberal Democrat’s Swinson loses seat

Conservative majority
Conservatives are on track for a winning a clear majority in the UK general election.
The campaign has centred on a core message of Get Brexit Done which has appealed to traditional Tories and disgruntled Labour voters in Leave-oriented constituencies.  Furthermore, a distrust of Labour’s leadership under a hard-left Corbyn has led to a significant reduction in Labour seats despite his popularity with youth activists.

A Brexit election
Each party’s position on Brexit has been the key driver for voting intentions, despite efforts by all parties to also focus on domestic policy and leadership personalities.
The Conservatives message was to get Brexit done.  The Liberal Democrats was to Revoke Article 50, ignore the Referendum result and remain.  Labour’s stance was to hold another referendum.  Voters, like markets, wanted clarity over “dither and delay”.

With a clear majority, and an unambiguous mandate to deliver Brexit, some say that ironically, the bigger the majority, the softer the Brexit as Johnson will not be held hostage by hard-Brexit supporting “ultras” from the European Research Group.  Meanwhile, Conservative MPs that have become independents or defected to the Liberal Democrats will vanish into obscurity.
 
Breaking through the “Red Wall”
The changing composition of the Conservative win is radical.  Whilst some remain-leaning Conservatives voters (and MPs) have shifted allegiance to the Liberal Democrats, constituencies in Labour’s northern heartlands known as the “Red Wall” because they have not had a Conservative MP since the 1930s or 1950s.  As predominantly Leave constituencies, voters have “lent” the Conservatives their vote as more trusted to deliver on Brexit after the shambles of a hung Parliament.

Strategist vindicated
Love him or hate him, the result is a vindication of Johnson’s chief strategist Dominic Cummings who developed Johnson’s core strategy on becoming Prime Minister in July 2019 as “D.U.D.” standing for Deliver Brexit, Unite the Country, Defeat Labour.  With the two D’s on track, it will then be for the U and a pivot to a domestic agenda once UK has left the EU on or before 31st January.
 
The Election in 3 Charts
1. Poll tracker
Based on an analysis of polling data by the BBC, average voting intentions on 11th December, the day before the election, pointed to 43% support for Conservative, 33% for Labour, and 12% for the Liberal Democrats.

Source: BBC
​
2. Cable
Sterling has rallied on exit polls that pointed to a clear Conservative win, with markets encouraged at the prospect at the end of political deadlock, the end of any risk of a hard left Labour government, and the beginning of constructive engagement with the EU to get a comprehensive trade deal in place by December 2020.
​
On becoming PM, Johnson forewarned that “people are going to lose their shirts” by betting against Brexit, using the language of investment managers.  For anyone short sterling over the past few weeks, that’s proven absolutely true.

3. ETF Flows focus on UK Small Caps
In the three weeks in the run up to the UK election, investors have been positioning for a Conservative win, with a record £151m flowing into the iShares MSCI UK Small Cap UCITS ETF (Ticker: CUKS) that focuses on domestically oriented smaller capitalisation companies.

1. Brexit uncertainty is weighing on the UK economy and market sentiment
2. We look at three scenarios: hard Brexit, extension, and last-minute deal
3. Diversification and tactical currency positioning is key

Political context
There is certainly going to be continued uncertainty in the run up to the Brexit Hallowe’en.  We outline three political scenarios.
Hard Brexit: whilst Parliament has successfully passed a law to ensure the Government must apply for an extension if they cannot reach a deal by 31st October, there is still a risk of a Hard Brexit as there is an outside chance that the EU would not win unanimity from the EU27 to agree to grant an extension.  31st October 2019 exit from the EU therefore remains the legal default.
Extension: if there is no deal by 31st October, and the UK Government seeks an extension from the EU and it is granted (for example 31st March 2020), then the can has been kicked down the road further, and there will likely be a General Election that will serve as a bitter and contested rerun of the Referendum campaign.  That General Election will either result in one of 1) a “Leave” mandate led by a fractured Conservative/Brexit Party, or 2) a “Remain” mandate from a Remain Alliance led by Lib Dems, or 3) a Labour government and second referendum.
Last-minute deal: there is an outside chance that the Prime Minister secures a Last-minute deal, that would be largely based on the existing Withdrawal Agreement, but with a Northern-Ireland only backstop.  Whilst this would be the ultimate in “government by essay crisis”, it would at least provide resolution to this 3½ year saga, tragedy, comedy or farce (depending on theatrical preference).

What about the economy?
To gauge the UK economic outlook, we look at three key indicators: Growth, Inflation and Interest Rates.
Growth: Despite low levels of unemployment, Brexit uncertainty is weighing on the UK economy with GDP contracting -0.2% in the second quarter.  Both manufacturing and service sectors have already shown signs of entering a downturn. The uncertainty around Brexit could slow the growth down even more. The GDP growth for 2019 is still projected at 1.2% by the Bank of England.
Inflation: Inflation is close to the Bank of England’s 2% target rate.  Although the UK inflation is currently subdued, the expected rate of inflation remained at 3.2% .  We estimate expected inflation using the 5 year breakeven rate, the difference between nominal and inflation-linked gilts yields.  Put simply, this means that the market is expecting a higher level of inflation over the next five years than at present.
Interest Rates: The UK yield curve continued to be flat at the end of 2q19. The spread between 2Y and 10Y bonds decreased further from 27bps to 21bps when compared with last quarter, the smallest gap since 2008. BoE’s chief Mark Carney’s recent speech warning an intensifying global risks added more concerns of a near-term recession.  In our view, there is no change to the “lower for longer” outlook for UK interest rates.

Asset class positioning
In the context of political and economic outlook, what are our views on asset classes?
Equities: Within an equity context, our portfolios do not have a domestic bias and are globally diversified, meaning that Brexit has limited impact on global equity risk compared to the bigger issues of the day, namely US-China trade disputes and US interest rate path.  For reference, the UK is only about 6% of global equities (when counting both developed and emerging markets).  So for globally diversified equity portfolios, Brexit has limited direct impact.
Equities are long run return drivers and are exposed to a broad range of currencies in terms of the revenues of the global companies that make up each market.
We do not believe that attempting to time the market for short run currency fluctuations, with regards to equity exposure, is worthwhile, and creates additional cost drag.
Key question: to hedge or not to hedge
However, for UK investors, currency positioning is key.  In 2016, advisers that allocated to unhedged global equity exposure, and/or focused on large cap UK equities (e.g. the FTSE100) which have a high proportion of dollar revenues protected their clients from sterling devaluation. 
Fig.1. World Equity Returns in GBP terms: unhedged vs hedged

Source: Elston research, Bloomberg data
​​Bonds: For bonds, most advisers rightly have a bias to domestic bonds for their clients to ensure alignment of client’s income and spending needs, as well as for protection in economic downturns (put simply: typically bond values are higher, when growth and interest rates are lower).
We expect UK interest rates to remain lower for longer under all 3 scenarios, whilst inflation remains contained.  If we saw risk of higher UK interest rates, we would look at allocating client assets to shorter duration (e.g. <5 year) UK bonds that are less sensitive to changes in interest rates.
Alternatives: Property: We like property as a real asset that offers inflation protection.  However, we see property as a potentially exposed asset class in the event of a no-deal Brexit.  We would be concerned by the risk of reduced economic activity, business relocations and higher vacancies.  For this reason our preference is for globally diversified funds that invest in shares of property companies, rather than for UK focused funds that invest in direct assets.
Alternatives: Commodities: We like commodities as a diversifier owing to their less correlated relationship with equities and bonds.  However as we are late in the cycle, we are cautious commodities.  However we see Gold as a traditional defensive asset in uncertain times, and note the risk of sustained upward pressure on oil prices amidst geopolitical tensions in the Middle East.

• Potential for GBP recovery in focus.
• ETPs enable rapid access to GBP exposure, if required
• Range of risk-return payoffs available depending on risk preference

 
Positioning for a GBP recovery?
With Brexit doom and gloom mostly priced in, all eyes are on sterling which has become the Brexit barometer.  So which way for sterling? Stating the obvious:

1. Prospect of any form of deal and GBP appreciates
2. Prospect of no deal and GBP depreciates

But finally – any prospect of an end to almost 3 years of uncertainty, and this could arguably could take some pressure of GBP too.
In the event of a relief rally in GBP, how can investors position portfolios accordingly?
 
Translation effect
Recall that the GBP currency impact on portfolios in 2016 was massive.  As GBP depreciated, investors whose global equity portfolios were unhedged enjoyed strong performance thanks to the translation effect of foreign earnings.  The same applied to FTSE 100 which looked stronger against a weakening GBP.

The reverse would also therefore be true.

Any significant appreciation in GBP would see (foreign) global equity returns offset by GBP strength and would weigh on the FTSE 100.  So for those who were lucky enough to be unhedged as sterling fell can’t rely on luck if sterling rises.

Toolkit for GBP recovery
Like everyone else, we have no crystal ball as to how Brexit could play out, but we can identify some of the tools that investors may want to have in their armoury to implement their views, whatever their risk posture, in case of a GBP recovery.

We look a selection of exchange traded products to access currency pairs, ultrashort bonds, shorter duration bond and GBP hedged equities to implement a tactical position for different risk levels.

1. Short-term currency exposure
On the approach to and in the event of any deal, for very short term exposure (<1 month), investors could consider gaining rapid currency exposure by using a currency pair ETC and if seeking additional risk could use a leveraged exposure.  Leveraged exposures should be short-term in nature and investors should ensure they understand the risks.
Currency pairs
GBPP: ETFS Long GBP Short USD
LGB3: ETFS 3x Long GBP Short USD

2. Volatility dampener
Investors can tactically allocate to ultrashort GBP bonds if they are looking for a cash-like volatility buffer with more yield than cash with a GBP return profile.
Ultrashort duration Bonds
ERNS: iShares GBP Ultrashort Bond ETF
JGST: JP Morgan GBP Ultra-Short Income UCITS ETF
 
3. Short duration bond exposure
Tactical allocations to short duration GBP bond exposures is available both for UK gilts and GBP corporate bonds for investors seeking GBP bond exposure without being over-exposed to interest rate risk from the longer-duration nature of the main indices.
Short duration Gilts
IGSL: iShares UK Gilts 0-5yr UCITS ETF
GLTS: SPDR® Bloomberg Barclays 0-5 Year Sterling Corporate Bond UCITS ETF
Short duration GBP Corporate Bonds
IS15: iShares £ Corp Bond 0-5yr UCITS ETF
SUKC: SPDR® Bloomberg Barclays 0-5 Year Sterling Corporate Bond UCITS ETF
 
4. Equities hedged to GBP
To access equities hedged to GBP, rather than running a currency overlay, investors can access GBP hedged versions of mainstream ETFs.  At 29-30bp TER, these are slightly more expensive than their conventional versions, but the cost difference represents the cost and convenience of running the currency overlay.  Most regional equity ETF exposures offer GBP hedged versions, or investors can use ETFs tracking MSCI World (GBP hedged) as a proxy for risk assets.  For example:
Global equities (GBP hedged)
IWDG: iShares Core MSCI World UCITS ETF GBP Hedged
XDWG: Xtrackers MSCI World UCITS ETF 2D – GBP Hedged

Conclusion
Whilst no deal is supposedly ruled out, there is no certainty as to what any deal would look like.  Whatever the politics, if you believe there is potential for a recovery in sterling, ETPs provide tactical ways of positioning portfolios accordingly.

  The  absence  of  a  clearly  defined  plan  for  Brexit  is  creating  damaging  uncertainty  for businesses and the markets. 
  Leaving the EU, but remaining in the EEA through EFTA would address the concerns of the majority of Referendum voters, whilst also requiring a spirit of compromise from both sides. 
  Joining  EFTA  would  immediately  provide  the  UK  with  continued  free  trade  within  the EU/EEA, a more valuable set of external Free Trade Agreements, and the added flexibility to negotiate its own free trade deals bilaterally. 
  Setting a timetable for re-joining EFTA provides a straightforward solution that will give the necessary confidence and direction to businesses and the markets whilst respecting the outcome of the EU Referendum.   
​This paper, drafted for but not published by the Centre for Policy Studies in July 2016, sets out the rationale for Britain in EFTA or "BREFTA" and calls for greater engagement with the "C10": the largest ten Commonwealth economies.

Confidence that UK equities having "made up lost ground" post-Brexit is misplaced.

The largest UK companies that make up the bulk of the FTSE 100 and the MSCI UK Index have high exposure to global earnings.

Apparent "strength" in the largest UK equities is just a translation effect of that revenue exposure.

So the apparent uptick in UK equities offers no real comfort for global USD-based investors.

For GBP-denominated ETFs tracking MSCI UK Equity (e.g. LSE:CSUK) performance is +3.7% since the EU Referendum Day 23rd June 2016 before votes were counted. Over the same period, the USD version of the same ETF (e.g. NYSEARCA:EWU) performance is -9.3% while sterling has weakened -12.4% (FXB).

Fig.1 Performance of MSCI UK (LSE:CSUK) in GBP since EU Referendum

• Growth rates cut compared to pre-referendum estimates
• Inflation estimates raised on weaker sterling, but possibly not far enough
• Focused spending on infrastructure and innovation is welcome

Growth estimates cut
UK GDP’s growth rate has been downgraded relative to pre-referendum expectations, with a cut from 2.2% to 1.4% for 2017E and from 2.1% to 1.7% for 2018E.

Inflation estimates raised
Following post-referendum sterling weakness, estimates for UK inflation were increased from 1.6% to 2.3% for 2017E and from 2.0% to 2.5% for 2018E.  This compares to 2.4% and 2.8% for 2017E and 2018E respectively for UK swap breakeven rates.

​Rising interest rate environment
With higher inflation expectations there is upward pressure on Bank Rates after a protracted “lower for longer” regime.

Spending focus: infrastructure and innovation 
The government spending plans shows clearly defined cous – with budget to increase infrastructure spending from 0.8% of GDP today to 1.0-1.2% from 2020.  This supply side stimulus that focuses on productivity gains is welcome if fiscally manageable.



NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.  I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.
This article has been written for a US and UK audience.  Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers.  For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.  This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates.  For information and disclaimers, please see www.elstonconsulting.co.uk 
Photo credit: www.gov.uk; Chart credit: OBR; Table credit: OBR Data, Bloomberg

• Trump looks set to become next US President
• Both pollsters and bookies called this totally wrong
• Asymmetric downside risk means near-term mark down of risk assets

Voting results
Trump swept to victory with 42 of 50 states declared, Trump leads Clinton 244 electoral votes to 215, with 26 to win, collecting 48.2% of the vote vs Clinton 47.1% (as at 0630 GMT today).

The result with 46 of 50 states declared gives a Trump win of 278 electoral votes to 218, with 48.0% of the Vote vs Clinton 47.3% (as at Trump acceptance speech).

Impact
EQUITIES: expect US equities (NYSEARCA:SPX; LON:CSPX) and global equities (NYSEARCA:ACWI; LON:SSAC) to be volatile, with emerging markets (NYSEARCA:EEM; LON:IEEM) to be negatively impacted, particularly Mexico (NYSEARCA:EWW; LON:CMXC).

From a sector perspective expect a positive reaction for financials (NYSEARCA:XLF; LON:SXLF), healthcare (NYSEARCA:XLV; LON:SXLV) and US infrastructure/utilities (NYSEARCA:XLU; LON:SXLU).

BONDS: expect near-term flight to safety driving government bond (NYSEARCA:TLT; LON:IGLO) yields down and prices up.

ALTERNATIVES: Expect flight to safety to drive relative outperformance in gold (NYSEARCA:SGOL; LON:GBS) and precious metals (NYSEARCA:GLTR; LON:AIGP), oil (NYSEARCA:IEO; LON:SPOG) as well as copper (NYSEARCA:JJC; LON:COPA).

CURRENCY: expect USD short-term weakness vs GBP, CHF and JPY.

Why pollsters got it wrong?
The result compares to pre-election polls of Clinton 46.8%, Trump 43.6%.  Pollsters got it wrong for two reasons 1) voter turnout amongst disaffected voters was higher so mix of voters in sample size is no longer indicative, and 2) “secret Trumpers” – voters who may not admit to voting for Trump in polls, but did.

• Following the Brexit Referendum a private legal challenge was mounted against the Government.
• The challengers argued that Parliamentary approval (rather than prerogative power) was needed before Article 50 was triggered.
• A High Court ruling yesterday agreed with the Challengers, throwing the Brexit timetable and the viability of the current Cabinet into doubt.

Who’s right?
Given Referendums are only advisory in nature, and sovereignty rests with Parliament alone, the case had merit. And yesterday’s ruling in the High Court, the three ruling Judges agreed.

The challengers maintain they are not contesting the referendum results, they just want legal process to be upheld.  Others suspect the campaign is partisan, but even if so, the case still deserves to be heard.

Parliamentary approval was required on the way in to Europe.  It should be required on the way out.

Rather than backing the down, the Government is taking the ruling to the Supreme Court in an attempt to get its way.  By digging in deeper they are potentially compounding the error of not calling an election the moment that May was anointed Prime Minister.

The fine line
While in the summer the new Cabinet felt it was riding high on the momentum of populist support, there is a fine line between democracy and demagoguery.

Had the Brexiteers had a clear plan for what happens next, there would not be a feeling of rushing headfirst into the unknown.

As winter approaches, the need for a cool tempered defence of the sovereignty of Parliament is hard for even the most committed Brexiteers to deny: particularly as sovereignty was at the heart of the Leave campaign.



Where’s the mandate?
The Conservative government had the referendum in their electoral mandate.  But not the mandate to act on its results.  Nor did the country vote for May to be Prime Minister May.  She should tread carefully.



Borrowed time
This leaves Prime Minister May with two unpalatable choices:

Either to call a snap election (she should have done this when she won the leadership contest) to confirm her mandate as leader and the mandate to trigger Article 50

Or to try to brush the inconvenient constitutional truth of Parliamentary approval by taking it to the Supreme Court.



Who’s afraid of an election?
The new Cabinet is scared of an election.  It could sweep them out of power and could push back further the decisive moment at which Article 50 is triggered as a new government reviews the position.

The toxicity in Westminster between Conservative factions means that the political body count of MPs with reputations smashed or jobs lost will continue to grow.  That is making the cabinet increasingly desperate.  And desperate politicians make bad choices.



Bottom line
Chances are this Cabinet will fall apart before Article 50 gets triggered, either through extended legal wrangling in the Supreme Court (not a pretty site) or in an attempt to win a mandate by calling an election. With their parliamentary majority so slim, and the dramatis personae so different there is no guarantee they would win.



[ENDS] 

NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.  I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.

This article has been written for a UK audience.  For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.  This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates.  For information and disclaimers, please see www.elstonconsulting.co.uk


Image credit: clipart.co; Chart credit: N/A; Table credit: N/A

• UK commentators are looking for data points that vindicate the Referendum result one way or the other
• Sterling’s slide and the FTSE 100 Index level together or in isolation are not the best indicators for a Brexit fear gauge
• The potential inflationary impact of a ‘hard Brexit’ has caused UK breakeven rates to spike, creating a real challenge for the Bank of England

Give me a sign
Just as high priests in Roman times, after slaughtering their offering, examined its entrails to gauge the Gods’ favour,  so too have UK commentators been searching for any statistical insight or market data point to declare whether the shock Brexit result is likely to lead to economic success or failure.

The data point phoney war
The data that has come out since the EU Referendum on 23rd June 2016 is meaningless as we still don’t know what Brexit looks like.  It’s been a phoney war for headlines, as stunned commentators search for a gauge to measure policymakers by.

When politicians use statistics, it’s dangerous. When they co-opt data, it’s dynamite.

First we had encouraging PMI Data.  Brexiteers (those who want the UK to leave) read this as vindication, which is a stretch to any rational observer given the pace of transmission in the economy.

Next we had Bremainers (Brits wanting the UK to remain in the EU) shouting “Pound Down/Told You So”, whilst Brexiteers shouting “Footsie Up/Told You So”.  It took a while for pundits to figure out that both sides were right, because they were unknowingly saying the same thing.  This is because the FTSE 100 (Footsie), consists of companies with predominantly overseas earnings.  Hence the UK’s bell-weather index gains were more a function of the pound’s slide, rather than any inherent strength in the economy.

Marmite makes it real
But perhaps what has hit home hardest is the 24-hour Marmite price spatbetween two behemoths, Unilever (NYSEARCA:UN; LON:ULVR) and Tesco (LON:TSCO), which led to a tabloid induced panic.

Marmite is the salty yeast-extract paste either loved or hated by Brits on their toast.  Its main ingredient is the sludge left over from brewing beer, so it seemed odd that a UK product with UK input costs should be at risk from a price hike.  But given Unilever’s equipment, cost of capital and investors are looking for Euro denominated returns, the impulse to raise prices was clear. So Unilever wanted to raise prices +10% to offset the -15% fall in the pound.

Tesco, the UK’s largest grocery, with enlightened self-interest wanted to shield consumers and share the pain with their supplier.  For the time being, retailers are shielding consumers from price rises.  But that go on forever.  The consumer pain from weaker currency will eventually be felt, and will have an inflationary impact.

Where is Golidlocks?
The true fear gauge for Brexit is therefore not currency alone, but currency and inflation expectations.
UK inflation expectation are reflected in the market by the “breakeven rate” – the implied inflation rate derived from the difference between conventional and inflation-linked gilts of the same maturity.  

This is the UK’s “quiet fear gauge” for Brexit, as it is not referenced in the tabloids.

On eve of Brexit vote, US & UK 5Y breakeven rate stood at 1.495% & 2.301% respectively.  The lower level in the US reflecting their stronger and faster recovery, steering the US economy away from deflationary fears following the Global Financial Crisis. The UK has followed a broadly similar path since the Global Financial Crisis, albeit at a higher level.

Chart 1: US and UK 5Y Breakeven Rates History

Source: Bloomberg: USGGBE05 Index & UKGGBE05 Index, rebased 31-Dec-07=100

Whilst a long way from the Goldilocks dream of moderate growth with inflation that was ‘just right’, the chart shows that the big bad deflationary wolf of 2008 has been vanquished by the fairytale money created by Quantitative Easing, and inflation targeting is, broadly, back on track. For now.

Hard Brexit is inflationary
Since the UK’s EU Referendum on 23rd June 2016, relative inflation expectations have dramatically diverged.  Whilst the US has notched up slightly to 1.584%, the UK has rocketed to 3.052%.  Unhappily for the UK’s new Prime Minister Theresa May, the bulk of this uplift can be pinned to her ‘Hard Brexit’ reference in her speech at the Conservative Party Conference on 2nd October 2016.

Chart 2: US and UK 5Y Breakeven Rates since UK’s EU Referendum

Source: Bloomberg: USGGBE05 Index & UKGGBE05 Index, rebased 23-Jun-16=100
The logic for this is brutally consistent.  Hard Brexit means harder trading conditions which means slower growth and weaker pound.  Slower growth and rising inflation is a painful combination, and would prove a gruesome challenge for the Bank of England.

Carney’s Mission Impossible?
Whilst deflation loomed, and inflation remained subdued, the era of ultra-low or zero interest rates was a possible and necessary lever of support.  If the Cabinet are hell-bent on hard Brexit, Governer Carney will face a near impossible mission:  to defy gravity by keep rising inflation in check (around the 2% target) whilst propping up the economy (and the markets) with a 0.25% Base Rate.

The Cabinet’s staunchest Brexiteers are still traumatised from ‘Project Fear’(when the machinery of Cameron’s government lined up behind “Remain”).  There is therefore additional political risk if Carney’s apprehension at this impending challenge is construed as partisan, and his position is made – by coercion or insinuation – untenable.  Personalities and emotions in the broken love triangle of Prime Minister, Chancellor and Governor will matter here.  In that respect the venality of the post-Brexit reshuffle is not encouraging.

Brexit: Hard or Soft?
The referendum result was not expected.  The change of the country’s and Conservative party’s leadership was not expected.  The post-referendum realisation that Brexit would actually happen was not expected.  The idea that the new Cabinet would go for a “hard” as opposed to “soft” Brexit takes the pain of this sequence of negative surprises to the limit.

Wishful thinking would suggest that perhaps the Cabinet’s discussion of a hard Brexit is a cunning plan to fox our EU counterparts before negotiations start?  Sadly, given the lack of preparation exhibited by the Brexiteers on their unexpected victory, that would ascribe too much credit, where none is due: whilst cunning was in abundance, there was no plan.

Inflation-protecting a portfolio
For US and UK portfolio investors, 1.5% and 3% respectively are now the hurdle rates if 5 year returns are to be ‘real’.

For long-term multi-asset investors, it is worth considering how best to inflation protect each element of their portfolio

• The fixed income element: high yield bonds (e.g. NYSEARCA:HYG; LON:GHYS) coupon payments are higher than this hurdle rate.  Inflation-linked government bonds (e.g. NYSEARCA:TIP; LON:INXG) offer direct inflation protection.  But the credit risk of the former and the duration risk of the latter, mean they are very both adversely sensitive to any potential rises in interest rates.
• The alternative element: alternative asset classes, such as property, where ETFs offer clearer liquidity (e.g. NYSEARCA:WPS; LSE:IWDP) and infrastructure (e.g. NYSEARCA:IGF; LSE:INFR).
• The equity element: defensive sectors with pricing power, and high dividends yields offer potentially the best inflation hedge for equity income investors (e.g. NYSEARCA:HDV; LSE:IUKD)
• The fee element: one final consideration where hurdle rates are increasing is to reduce fee drag: the declining prices from ETF providers is supportive in this respect.

No clear plan
Either a clear Remain vote, or a clear Leave vote with a prompt articulation of what Brexit means (the Norway model? the Turkish model? the Swiss model?) would have given UK markets the certainty investors crave.

But now four months on, the Government is, it seems, simply making up what Brexit means as we go along, and trying to keep irreconcilable interest groups happy.  There seems to be one message from the Government to Japanese car manufacturers, another to the City, another to the EU, and very little, of course, to the electorate: just that, with crypto-clarity “Brexit means Brexit”.

A real fear gauge
This lack of clarity and lack of direction is creating real economic costs, and will ultimately hit everyone in the pocket for more than just Marmite.  The upward march of the UK breakeven rate is the fear gauge for that: watch it.

NOTICES
I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.  I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.
This article has been written for a US and UK audience.  Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers.  For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.  This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates.  For information on Elston’s research, products and services, please see www.elstonconsulting.co.uk
Photo credit: Google Images; Chart credit: Bloomberg Professional; Table credit: N/A

Brexit it is
The U.K. public has voted to leave the European Union after 43 years in yesterday's referendum.  Leave has 51.7% of votes so far with 71.8% turnout (higher than previous general election) suggests a vote for Brexit by a narrow margin.  The leaving process could take a minimum of two years, and even Leave campaigners don't expect the process to complete until 2020.
​
Opinion polls were too close to call
​Polling pointed to a closer result and recent momentum for the Remain campaign which had given markets an element of (false) security: the final poll put 45% Leave, 44% Remain, 11% Don't Know. While the binary nature of the debate suggested that those undecided might abstain, turnout has been high at 72%, despite (you guessed it) bad weather.

Source: BBC
Article 50
The Prime Minister, David Cameron, must now decide whether invoke Article 50 of the Treaty of Lisbon (to leave the EU) which starts a 2-year exit negotiation process. If not invoked, there is potentially more time for negotiation, but it would create additional uncertainty, in terms of direction, timing and mandate.
Experts ignored
The Remain campaign was able to rely on the expertise of economists, business leaders, and international bodies such as the IMF, all warning of dire economic and security consequences under a Brexit scenario. The Leave camp, in rebellious vein, dismissed this as "project fear" being rolled out by a self-serving elite. Ultimately, the vote was as much about emotions as it was about argument.
U.K. fragmentation
​One of the second-order risks that the Referendum has unleashed is the risk of the U.K. finding itself regionally split. At present, England is 53.2% Leave on 72.9% turnout and Wales is 52.5% Leave on 71.7% turnout. By contrast, Scotland is 62.0% Remain on 67.2% turnout, and Northern Ireland is 55.8% Remain on 62.9% turnout. One of the unintended consequences of a "Brexit" from the EU could be an independent Scotland remaining part of the EU. How Northern Ireland would be affected if it is outwith the EU with an open border with the Republic of Ireland that is within the EU is also going to require focus.

Legend: Blue - Leave, Yellow - Remain
Source: BBC
EU angst
With the U.K. being the first country to leave the EU, a precedent will now be set. Remaining members of the bloc may also start to "think the unthinkable." Brexit will shake the foundations of the European project and trigger introspection in Brussels and, possibly, reform. Ironically, a reformed EU (focusing on trade only, without ambitions of statehood) is something that many Leave campaigners would want. But the vote suggests that expectations in the ability of the EU to reform are low.
Markets
​Whereas a Remain vote would have enabled a business as usual relief rally, the Brexit vote means prolonged uncertainty as the U.K. attempts to shape what its future looks like outwith the EU.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credits: BBC Photo credit: George Hodan

• Policy makers are deploying unorthodox tools to solve orthodox problems.
• Negative interest rate policy is a new policy lever that has been deployed in Japan, Europe and Sweden.
• Moving to NIRP would be a reversal of the Fed's December 2015 rate rise, and is an untested policy.

The Japanese did it. The Europeans did it. Even the educated Swedes did it. So will the Fed ever lower interest rates below zero?
Markets fell out of bed last week on fears the Fed might shift from a Zero-Interest Rate Policy ("ZIRP") that alleviated the pain of the financial crisis to a Negative Interest Rate Policy ("NIRP") to keep the monetary stimulus to the economy alive.

Why does it matter
The "feasibility study" being undertaken at this stage is a long way from a policy announcement, but would indicate a very different interest rate path to December's announcement. This volte face alone would query the Fed's credibility.
Add to that the known unknown of how markets might operate in this Through the Looking Glass world where you pay to lend money to the lender of last resort, and some basic assumptions around the supply of, and return on, capital have to be adapted.

How does it "work"?
The short answer is: we'll see. In theory, by charging financial institutions to sit on surplus cash, they are forced to put that cash to work, for example lending to corporates to keep their wheels turning. In this way, negative rates act as a stimulus to the velocity of money, rather than the quantum of money supply.

What are the issues?
Issue number one is that it turns the fundamental relationship between providers and users of capital on its head. Aside from that are the legal and technical issues around how NIRP can be implemented in any jurisdiction. But, as we have seen so far - where there's a will there's a way.
The sector most vulnerable is the banking sector as negative interest rates wreak havoc on Net Interest Margins - the spread between banks' borrowing and lending rates that is the cornerstone of their profitability. Hence the rather brutal round of price discovery that took place in the banking sector as a response to this new known unknown.

From negative yields to negative rates
Short-term real yields on government debt (i.e. nominal yields, adjusted for inflation) went negative in 2008 during the financial crisis. Short-term nominal yields on government bonds, issued by, for example, the US and Germany, have dipped in and out of negative territory thereafter, as a safety/fear trade signaling that those investors would rather pay governments to guarantee a return OF their capital, than demand corporates to promise a return ON their capital.
So economically speaking, negative yields are not new. But what is new is that negative interest rates are being adopted as a central bank policy.

How have markets reacted?
Markets hates grappling with new concepts where there is no empirical data from the past on which to make hypotheses. Hence the "shock" increase in risk premia despite the ostensible further lowering of the cost of capital. Renewed interest in gold is the natural reflex for those scratching their head as monetary policy grows "curiouser and curiouser".

What next?
Central banks are adding NIRP to the armory of "unorthodox" levers at theirdisposal to achieve orthodox aims. To what extent this new weapon is deployed will depend on the underlying development in fundamentals around growth, jobless rates and inflation targeting. Those targets set the course to which monetary policy will steer. Whether the new policy levers have more efficacy than the old remains to be seen.

Baked beans, anyone?
The UK's baked bean price war of the mid 1990s, provides a parallel to the topsy turvey economics of negative pricing. To gain and retain customer market share, the big three British supermarkets slashed baked bean prices to around 10p a tin. Tesco's then broke ranks and slashed prices further to 3p a tin (subject to max 4 cans per customer per day). Not to be outdone by its bigger rivals, Chris Sanders of Sanders supermarket in Lympsham, Weston Super Mare made history by selling baked beans for MINUS Two Pence (subject to max 1 can per customer per day). Janet Yellen - you now know whom to call.
While it didn't alter the fundamentals of the retail sector, it did mark the end of an irrational era of skewed economics. For the optimists out there, perhaps NIRP heralds the same?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.