Market Memo: Recent trip to Europe confirms 'cloudy with a chance of sun' forecast

06-14-2016

We have just returned from Europe. There we had the opportunity to meet with senior politicians and a large institutional investor in Germany, investors and government officials in Ireland, about a dozen U.K.-based companies in which we are either invested or are considering investment should that market break in a Brexit-induced correction, as well as senior economists from across the continent. Sometimes trips like this bring new insights; sometimes they simply bring greater conviction in a pre-existing view. This one brought a little of both. Here is a quick summary:

  • Brexit is more possible than most people imagine. The more we talked with the people we met with in the U.K. and listened to local news channels, the more we saw the country’s vote to exit the European Union as a real possibility. Many in Britain are frustrated with the faraway government in Brussels impinging on their ability to make their own decisions. This frustration is magnified by the issue of open EU borders and immigration. The “Remain” camp’s message is fundamentally unappealing and almost unnationalistic in its implication that Britain is somehow too weak to be able to operate as an independent country. If the “Remains” win, it will be because of young voter turnout being higher than is being picked up in the polls. These young voters tend to be less U.K.-centric and more pro-EU, and drives were underway when we were there to register as many of these voters as possible. Bottom line: Brexit remains too close to call. The outcome could depend on the weather in London (the city is heavily pro-Europe) on June 23. Unfortunately for the markets, London has some of the rainiest weather in the world.
  • However the vote goes, Brexit won’t end concerns about the continuity of the EU. A new insight from our travels around the continent is that Brexit anxiety is in some ways part of the same anti-globalization fervor fueling Donald Trump’s presidential bid here, as well as the rise of right-wing parties in Spain, France, and importantly, Germany. These forces will remain in play with or without Brexit so, unfortunately, the vote on June 23 is unlikely to end the debate within Europe around the viability of the EU. Uncertainty about the ultimate form and substance of the EU is likely to continue for years to come. Investors will have to get used to this.
  • U.K. companies will survive Brexit fundamentally, and may even thrive, provided the financial markets don’t overreact. A bit of good news is that virtually all the companies we met with believed that while Brexit would be unsettling from a macro point of view, at a micro level they would be able to manage through it fairly well. In some cases, they would simply shift their nominal headquarters to a pre-existing EU-based subsidiary. In other cases, they would shift key operating units to Ireland or some other friendly EU location. No one believed a Brexit would single-handedly derail their business. But all bets are off if a crisis in the British pound leads to a level of market instability sufficient to create a negative feedback loop on the U.K./European economy.
  • Emerging markets have become a country-by-country call. We spoke with several large U.K. companies doing business across the emerging markets. It is clear that emerging markets have increasingly become a country-by-country call, rather than a monolithic asset class. In Latin America, Mexico is booming while Brazil is struggling. In Africa, Nigeria is challenged while Kenya is strong. In Asia, India is growing while China is struggling. Investment strategies oriented towards getting the emerging-country call right first, and the stocks second, seem to make sense right now.
  • For now, big global dividend players (read, DEFENSE) remain the winning strategy. Most of the big global dividend-paying companies we met were relatively unexciting, working hard every day to produce very modest growth in a globally low-growth environment, but throwing off lots of cash to support the relatively high dividend checks they send to their shareholder bases. Many of these companies’ dividend yields are still in the 4 to 5% range, which is well above investment-grade corporate bond yields in Europe and the U.S.—and, of course, way above what investors can get in risk-free government bonds. With global central banks determined to hold fixed-income yields low, money should continue to flow toward the big dividend payers. Defensive, dividend-oriented strategies have been outperforming year to date and, in this world of uncertainty, such strategies seem destined to continue doing so.

So we remain cautious. With the market fairly priced on fundamentals, we continue to urge caution in front of the Brexit vote. A “Leave” win will likely further destabilize currency markets and probably stock markets as well; a “Remain” vote could provide a sigh of relief, at least until investors begin to worry about who in Europe is next, China, the pending Federal Reserve rate hike and the uncertain outcomes surrounding the U.S. election. If we can begin to get more clarity on these assorted fronts, and/or get to market levels where the risk/return is in better balance, betting on the sun shining again will make sense. For now, stay defensive.