Brexit and the Inevitable Panic

As you have likely already read, the United Kingdom voted in a referendum to leave the European Union yesterday. While there are some complicating factors, the turnout and margin were sufficiently large to indicate that there is no going back.

This result was unexpected by most investors and will have significant political, economic and legal implications for both the UK and the EU. Consequently, we are seeing dramatic declines in various stock indices in virtually all markets - including the US. 

While I expect that our portfolios will experience some decline in value as a result of this development, I expect the impact to be relatively limited and short-term in duration. Our clients generally have considerably less exposure to the foreign stocks than the “average” diversified, professionally-managed investor. And, the process of the UK’s withdrawal from the EU will be a long and complex one. 

Accordingly, this development does not justify any changes in investment strategy at this point.

However, markets trade on anticipation and exaggerate the significance of such developments. As I’ve argued throughout this year, I expect to see volatility in 2016, and the next few days are unlikely to disappoint. 

I’m reminded of the old J.P. Morgan axiom that the best time to buy is when “there’s blood in the streets.” If we do see significant sell offs, this would likely justify most clients increasing their exposure to equites overall, and UK stocks in particular. 

In short, I don’t recommend making any significant moves, other than to see this as possibly a buying opportunity for UK and European stocks in relatively small amounts in the coming days and weeks.

Puerto Rico, Apple and Goldman Sachs

The markets have firmed up quite a bit in the last couple of months, but we’re likely to be in for a rocky summer.  Summer has a tendency to be volatile. Earnings reports are mixed and diverse - Apple is clearly entered a soft patch, but Facebook is charging forward and beating estimates.("Sell in May and go away.")

Companies overall are maintaining spending at relatively modest levels,  while consumers are belt-tightening. We’ve seen some increases in the individual savings rate, suggesting that behavior is shifting towards more conservatism. Data says they’re optimistic about their prospects, but are very concerned about the future. (This is usually a good predictor for the markets, ironically.)

Probably the most attention grabbing issue is Puerto Rico, which will be upping the ante in a new phase of its bankruptcy with a negotiated default on a 'Puerto Rico Government Development Bank' bond that came due on the 2nd. This was predictable but one thing is clear - the matter is far from resolved.

What’s significant about this recent change is that it now unquestionably places the territorial government in “default." This particular defaulted GDB bond was a little different in that it’s specific holders were a fairly concentrated group. It looks like the pool of hedge funds / mutual fund investors will get something between $0.45 and $0.55 on the $1 for the face value of the bonds (plus all of the high interest they collected over the last few years.)  

The Puerto Rican government (PR) seem to be genuinely committed to avoid a default on the General Obligation (GO) debt. A default would be unprecedented, and PR’s pretty much stated policy at this point is to try to heavily bail out the GO bondholders -- by imposing much worse terms on the non-GO debtholders (the electric utility, the Development Bank, highway bonds, etc) in the hopes of continuing their future access to the bond market.

Nobody has confidence in the locals’ solution, and everyone is waiting for congress, or the Supreme Court, to act, so we have paralysis. We should expect more defaults, and more rhetoric in the coming months.

What this means, is that (barring some miracle), the process of resolution will likely head well into next year and we still don’t know what ‘resolution’ will look like. Investors need to be patient and let the process work itself out. Everyone agrees that Puerto Rico needs access to a bankruptcy process, and there is now pretty much consensus from the mainland institutions that a Financial Control Board needs to be put in place. At issue is how powerful the board would be and over several labor and tax / entitlement reforms. We’re still working things out I remain confident that the matter will be eventually be resolved, but not fully until next year. 

Much more interesting and indicative of the current economic environment was Apple’s disappointing revenue growth over the last year (worst in 13 years.) It’s certainly gotten a lot of investors worried that Apple has ‘lost its mojo.’ 

Largely unnoticed was that Apple is increasing its dividend considerably (9%) and buying back more shares. At its current dividend, strong financials; I think it’s hard not to make the case that the company is both an attractive, stable company with both near term and long term prospects. Its main problem is that it’s too big in terms of market capitalization, and its non-dividend growth shouldn’t be expected to be too high in the future. I see Apple is a “value stock” and an "income play."

But it’s true, the problem with Apple isn’t confined to its sheer size. The last few products the company put out were disappointing. But the company has a long history of innovation, and seems to have the best minds in the industry. (And, even without high growth in the future, it’s income yield is equivalent to US treasuries.)

Finally, on a more pleasant note - it’s interesting that Goldman Sachs has chosen to enter the online banking world and start collecting retail deposits. This might be a great way to leverage their brand. They’ve recently announced some very attractive cash management products. (1% on money market; Apparently their status as a bank holding company really encourages them to try and bulk up on deposits.) 

We’ll see if they’re serious about gathering retail deposits in the coming year, but the high interest they’re offering is an extremely encouraging sign and a reason to look both placing cash positions there and to look at the stock. 

Taxes and Campaign 2008

In the last two weeks, there has been significant press on the tax reform proposals of both Presidential candidates. Both platforms include substantial tax reductions. Unsurprisingly, McCain's cuts are likely to disproportionately favor the largest taxpayers, while the benefits of Obama's cuts would primarily effect lower income Americans. An excellent study by the Urban Institute concludes that "[The candidates] specific non-health tax proposals would reduce tax revenues by $3.7 trillion (McCain) and $2.7 trillion (Obama) over the next 10 years, or approximately 10 and 7 percent of the revenues scheduled for collection under current law, respectively." Both candidates advocate continuing the 2001 Bush Tax Cuts to some degree and both are arguing for new reductions in the corporate income tax rates, but there are some significant differences in their approaches and, as with all things, the devil is in the details.

What, on the surface, may seem like very similar proposals would have potentially very different effects on the capital markets and broad implications for our clients. Both plans have components that would dramatically influence tax receipts and the economy in general. In particular Sen. Obama's expressed desire to see both long and short term capital gains taxes increased on most assets is quite concerning, because such an increase is likely to discourage the movement of capital and this hinders the proper functioning of markets.

However, his proposals to see capital gains completely eliminated for "startups" is extremely attractive as historically innovation and jobs have overwhelmingly originated from smaller firms and such an approach would seem to be highly stimulative. What Obama's proposal represents as much as anything is the transformation of the Democratic Party - particularly the increasing dominance of Venture Capitalists and other types of financiers. Such a proposal is likely to be treated with a great deal of skepticism for the fact that the Democratic party has a less-than-stellar historic track record (nationally) of supporting small business and many forces in the party (most notably House Ways and Means Committee Chairman Charlie Rangel [D-NY])have actually argued for the rolling back of standing tax legislation that supports venture capital and private equity. It is reasonable to believe that President Obama may find a great deal of resistance to his proposals from old line Democrats, similar to the experience of Carter and Clinton following their elections as relatively economically conservative democrats.

What is most striking is that neither candidate seems to want to commit to balanced budgets in the coming future. By their own admission, but candidates would substantially worsen the fiscal situation of the federal government (at least in the short term), which many observers (myself included) would argue that this will likely highten a general sense of unease and uncertainty with the influence long-term investment patterns negatively. It's reasonable to expect significant resistance to their agendas from fiscal conservatives on either side of the aisle.

I plan on giving a detailed review of the tax proposals of both candidates in a presentation early next month.