This is a copy of an email sent to all AvalonFS representatives on 26/6/2016:
I thought it wise to send out a communique given the market volatility caused by Brexit.
The Brexit decision, albeit a stupid way to run a referendum on such an important matter, to leave the EU was completely unexpected and has and will continue to cause for some time, significant market volatility.
Although nothing in Europe or the UK is likely to change short term and company fundamentals have not changed since yesterday, the volatility is disturbing and is caused by political risk with concerns of contagion risk, rather than any fundamental shift in the economic environment of the UK or the EU.
The danger of contagion risk is twofold. Firstly the potential of a particular countries liquidity markets to ‘dry up’ much like we saw during the GFC, cascading across the globe. This is of real concern and we are already seeing spreads widen. Hopefully there are no significant hedge funds leveraged to the hilt with short term debt. If this is the case we could see spreads widen more if one of these collapses`.
Secondly the risk of other members leaving the EU on the back of the UK decision will cause further destabilisation.
The current treaties the UK has in place will continue and although Article 50 provides a plan for the unwinding of a country from the EU, it may not necessarily be or need to be invoked.
The UK will, at some point, begin to negotiate with other countries but in the meantime business continues as normal across Europe. Apart from contagion risk. The short-term impact on business is likely to be the effect of currency movements, and this may be huge and we have already seen the GPD at its lowest level since 1985. Currency weakness will improve the competitiveness of UK exports, and the earnings of overseas earners will be revised upwards. On the negative side inputs from the EU and elsewhere will see costs increases and this will affect some industries. The impact on the EU should be marginal, with UK growth, and this has been the best growth period for the UK for at least 30 years, likely to ebb for how long is anybody’s guess.
There is also the likelihood of the disaffection of UK goods, or ‘sour grapes’ attitude developing and as well as the UK being becoming more insular.
Within the UK we are seeing further political instability. Scotland is tabling a further referendum to become independent.
Make no mistake, this time it will pass because the Scottish vote to stay part of the UK was partly premised on it [UK] staying in the EU. Then Scotland will join the EU. This of course is likely to have the effect of some joint manufacturing companies working with the EU now, will move to Scotland (or Ireland now for that matter). It does not look good for the UK long term.
If you have investors who like the UK the best opportunities may come from international businesses listed in the UK and Europe that are sold off with the market (systematic risk), but whose trading will not be impacted by the decision and who may benefit from currency weakness.
UK companies such as Tesco, and British Telecom will continue to make profit a sthey are largely inward facing, although in the case of Tesco, its European inputs, as stated previously will cost more, but these increases will be passed on to the consumer. The same goes for British Telecom, hardware imports will be more expensive, but again will be passed on. Note the marginal issues associated with the above companies.
That is people will still continue to buy goods and services from them. Companies such as Rolls Royce would likely move to Ireland or Scotland as they supply engines for Aerobus.
Then there is Northern Ireland. Despite the Protestant – v- Catholic issues, a united Ireland is likely as it, like Scotland had a majority ‘Stay’ vote, and for good reason.
Ireland has become an economic hub for the EU.
Unfortunately for the UK, car production is non-existent and so the cost of these imports will increase and as these items are largely discretionary from a new car perspective, European car companies may see profits drop. The UK does not buy, in any real numbers, cars from the US.
UK Financials are likely to suffer, although the UK is net exporter of debt.
So to Australia. It borrows. It is a net importer of debt. Spreads will move, if they haven’t already. This means our banks cost of funds will rise and pure Hedge funds, not those classified as hedge funds by ASIC, will be squeezed. The RBA should respond by providing alternative funding, but this is Australia so who knows it doesn’t seem to have much imagination.
Speaking from my time with APRA I would suggest that the current tightening of the lending criteria across the banks is likely to loosen up again. However, if labour gets in at the election, all bets are off. The capital gains discount moving from 50% to 25% and the removal of negative gearing on built properties will cause a massive shock to the housing market. Before the UK vote it was predicted that asset devaluation in Australia would have been approximately $580,000,000,000. With Brexit added to the mix who knows what will occur, but it won’t be positive.
Stocks and Margin Lending
None of you should have any real exposure to the resources sector, which should also suffer in the short run. Long run will be dependent of course on continuing global growth.
Those of you with margin lending clients should unwind their banks and other financials with global exposure, at least for the short term until we know how far these will fall. This will present you with better options for other stocks sold off way beyond their value. And remember, as far as AVALON is concerned the MAXIMUM leverage is 50% so if the banks drop more on Monday, and they will, you need to calls some margins and get it back under 50%.
Stocks to pick up should include those with their client bases in Asia and Australia paying high dividend yields such as Telstra (slightly up), GUD Holdings down 1.54%, ASX etc. These, at least in theory, should not be overly affected by what happens in the EU and global markets. General advice on portfolios is, good defensive stocks paying good dividends and moving a good proportion to cash.
I am sure that I am telling my grandmother to suck eggs, but remember, when the market is this volatile you need to stay in close contact with your clients.
BREXIT: An alternative view
First, let’s state the bleeding obvious – uncertainty leads to fear and fear leads to volatility.
The BREXIT will lead to probably the most uncertain period on world markets since the GFC, but more importantly it could lead to the biggest opportunities since the GFC. Unfortunately, I do not believe we will get as many opportunities as we did during the GFC but that doesn’t mean opportunities won’t arise.
We saw the initial reaction on Friday to the BREXIT was a 3% drop in the Australian market, similar falls in the US/UK and almost 7% in Germany.
Personally, I believe that over the coming weeks we could see total falls of around 10-15% in major markets. This could be potentially more if the BREXIT is followed by a Frexit, Grexit or Romexit. Scotland leaving the UK could have a smaller impact and mainly on the UK Markets.
Why was the Leave campaign successful?
Simply put the “Remain” campaign lost the vote more than the “Leave” campaign winning. The problem with the Remain campaign is that a large part of their supporters are Gen Y’ers. These are people who whilst happy to use Social Media to push their case and click on a survey to say they supported the Remain option, actually forgot that they needed to turn up on the day to vote.
If you doubt something so simple could swing the referendum have a look at the turnout rates in the areas that have the largest portion of 18-24 year old voters. By contrast, those areas with the highest percentage of elderly people almost entirely voted to Leave (27 out of 30 areas).
These young people are now leading the call for a 2nd referendum, which to me reflects the fact that for too long they have been lead to believe they will always get their own way. They now feel that they should get a second bite of the apple because the vote was close – I wonder if they would be calling for a 2nd referendum if they had won by the same margin?
I find it interesting that those who are aged 45 and over were most likely to have voted to Leave. These are the people who have lived with the UK being both inside and outside the EU.
It would be unfair to solely blame young voters who failed to turn up for the loss, it also had to do with the fact that many people, on both sides of politics, are feed up with the UK not being able to control its own borders and economy. This is a similar feeling to that driving support for Donald Trump in the USA and it will be interesting to see how many of the young people who have been supporting Bernie Sanders actually turn out to vote for Hillary Clinton in November.
Lastly, whilst a 52:48 vote appears to be close – was it really that close? The Leave campaign won in 270 counting areas, the Remain campaign only 129. Further the Remain campaign only won 3 out of 12 regional areas, with two of these being amongst the 5 smallest regional areas. Out of the 5 regions with more than 3 Million votes cast the Leave campaign won 4 of them, losing only London.
Is the BREXIT actually bad thing for the UK?
As far as the UK is concerned I do not believe it is.
- Despite having been part of the EU since 1973, at no stage did the UK fully embrace the EU. Most notably the UK never gave up control of its currency, being only 1 of 3 Western European EU Members to retain their own currency.
- The UK represents 1/6th of the EU’s GDP second to only Germany and slightly ahead of France. I believe that the EU lose more from the BREXIT than the UK does, particularly in terms of credibility.
- Since 1999 UK exports have roughly doubled to around ½ Trillion pounds. During that time the percentage of these exports going to EU member states has fallen from 55% to 45%, despite the number of EU members increasing from 14 to 27 in the same period.
- Exports to non-EU countries has increased by an average of 6.5% per annum between 1999 and 2014 compared with 3.6% per annum to the EU during the same period.
- Imports from EU countries has remained around 50-55% of total imports during the same period.
- The UK has a trade surplus with non-EU countries and a trade deficit with EU countries.
Given that the EU countries sell more goods and services to the UK than they purchase, I do not believe that they will be looking to cut off ties or impose tariffs on UK goods following the BREXIT.
So whilst I do not see the BREXIT impacting dramatically on the UK’s trade with the EU I can see benefits in relation to trade with non-EU countries. This is due to the fact that the UK will now be free to negotiate its own trade agreement with non-EU nations.
Under the rules of the EU, member states are not able to negotiate a trade agreement unless it is approved by the other 27 member nations. This has held up many trade agreements over recent years as self interest by some nations over rides what would be best for the other 27 nations. An example of this is Australia’s inability to negotiate a free trade agreement with the EU due to Italy refusing to sign-off on it due to Australia imposing anti-dumping tariffs on Italian canned tomatoes.
Free of the EU shackles the UK will now be free to pursue free trade agreements with some of it’s major trading partners including China, the US and Australia.
Despite the UK voting in favour of leaving the EU, this wasn’t reflected in all member states. England and Wales voted to leave but Scotland and Northern Island voted to remain. Immediately following the result Nicola Sturgeon, Scotland’s First Minister, was calling for a 2nd Scotish Independence Referendum in order that they could remain part of the EU.
Latest polling in Scotland indicates that although 47% of people indicated that they would vote for independence only 42% of people actually wanted a 2nd referendum. Given that only days after 62% of Scottish people voting to remain in the EU only 42% want an Independence referendum I highly doubt that such as referendum would get up even if it was to occur.
If England was to run a campaign telling Scots that a vote to leave the UK and join the EU would mean losing access to the British Pound and an inability to enter the remainder of the UK without a Visa I think that the chances of success would be even lower.
Where to from here for the UK?
My personal opinion is that I would sooner be exposed to the UK economy for the next 5 years than the EU economy. I don’t know if we will look back and see this as being the end of the EU or not, but I am certain that last Friday was the day when the EU became weaker and the UK became stronger.
The UK needs to move to rapidly appoint a new leadership team (not wait until October) to guide it through the forthcoming dealings with the EU. The swifter the separation the better for markets around the world.
I do not foresee a prolonged recession in the UK, but given that a recession is only 2 consecutive quarters of negative growth it is 50:50 as to if one will officially occur. This would most likely be on the back of some companies choosing to relocate to the EU to better reflect that companies natural market.
These companies relocating and flow on effects from leaving the EU will result in lower revenue for the UK Government, but does that matter? Well it depends upon how much of a Budget impact that is and what off-sets in expenditure come from leaving. For example, the UK contributed £10.4 Billion to the EU Budget last year something that will cease when they leave the EU.
More importantly, the ability to refuse to accept people with EU Member Country passports in to the UK could save billions of pounds per year in welfare payments.
What do you do about your client’s investments?
There are generally speaking three strategies that can be applied to your clients investment strategies:
- The Chicken Little Strategy
This is where you, or your client, decide that we are now facing the end of the world as we know it and sell everything placing the money in the Bank or under your bed. You then wait for the markets to recover and repurchase shares once everything has stabilised.
Pro: No calls from clients worried about the volatility we might see over the next few months or years.
Cons: Bank interest is very low and your clients could potentially miss out on a lot of income and tax credits whilst their funds sit in cash. Also, how do you know when the right time to re-enter the market is?
- The Steady as she Goes Strategy
Sometimes doing nothing can be the best tactical strategy, but this is on the premise that you have an appropriate strategy in place for your clients needs.
If you have a portfolio established that delivers a consistently growing income stream for your clients (such as the PacReef Income Today Portfolio) and appropriate levels of cash/fixed interest outside of this portfolio (personally I recommend 24-36 months drawings) your clients should enjoy a worry free time.
Pro: If the clients understand the strategy they will rest well at night, you will not receive worried phone calls and your clients will not see their lifestyle impacted.
Con: If your clients do not understand the strategy, now is not the time to be trying to explain it as they will only be focused on the current volatility not the income being received
- The Income Booster Strategy
This strategy is for those clients who have not started to draw on the income produced by their portfolio, but are looking to boost the level of income they will receive in 5-10 years time.
For these clients you could consider the use of Self-Funding Instalment Warrants if we see significant falls in the price of high quality income producing stocks. Here’s how it worked during the GFC:
Between the end of 2007 and the beginning of 2009 Wesfarmers share price fell from $40 to $20. Now most people, even at that time, would still have agreed that Wesfarmers was a high quality company.
If you had held 1,000 Wesfarmers shares at the end of 2007 they would have been worth approximately $40,000 and been generating for you $2,250 per annum in income fully franked.
When the shares fell to $20 each you had the opportunity to swap them for 2,000 Wesfarmers Self Funding Instalment Warrants each with a $10 loan attached (50% gearing). Since that time the dividends from these shares has been sufficient to fully repay the loan and you now would own 2,000 shares worth $40 each.
This means that not only do you now have $80,000 worth of shares but more importantly you are now generating an annual income $4,040 per annum fully franked. This means that your clients will have increased their income by 80% and the value of their shares by 100% over an 8 ½ year period.
Pro: Self-Funding Instalment Warrants should be a principal and interest loan. They should not have margin calls. Ability to enhance clients’ income once repaid. Can be repaid at any time. Lower the breakeven point for the client.
Cons: Increased volatility due to gearing. Not all Self Funding Instalment Warrants are the same.
So there you have it. My thoughts on the BREXIT and some ideas of how to approach it with clients.