European Secession Votes and Market Implications: Scotland

Stuart P. Quint, CFA, Senior Investment Manager and International Strategist

This first blog in a two-part series will examine the Scottish secession vote coming in September and the potential implications for financial markets. The second blog will delve into the Catalan vote in November.

“There is the real possibility of one or several national divorces being initiated in Western Europe in 2014,” opines Nicholas Siegel, program officer at the Transatlantic Academy, a U.S.-European think-tank based in Washington.[1]

Secession votes will be held in the UK in September over the future of Scotland and in Spain in November over the future of Catalunya. It appears unlikely that either will result in a real separation of the regions from these nations. However, financial markets should still monitor the progress of these votes. Markets appear to discount a rejection of secession. If voters in one of these regions were to vote for secession, that could trigger near-term volatility. Regardless, these votes highlight fragility in the fabric of the European Union that warrants monitoring.

Voters in Scotland will elect whether to remain a part of the United Kingdom or to secede and claim independence. A “Yes” vote would lead to binding negotiations between the Scottish and UK Governments for eventual secession. Recent polls suggest pro-independence voters will not succeed as a plurality of voters leans against independence.[2]

In the event of a vote for independence, complications both for the UK and Scotland could ensue. The size of the economy and population of Scotland is less than 10% of the UK; yet, these statistics conceal a few hurdles. Much of the energy produced within the UK falls within Scottish jurisdiction. Many UK financial services companies are based in Scotland (though the majority of their revenues derive from outside Scotland). Moreover, the Bank of England has stated that Scotland would have to use its own currency instead of the British Pound Sterling.

The costs of independence could bring with them financial turmoil at least for an independent Scotland. However, the UK itself might not go unscathed as the British Pound Sterling is a reserve currency that could lose support. Major corporations, such as Standard Life, could relocate from Scotland back to the UK

Even a “No” vote, though, does not necessarily put an end to the matter. A narrow vote could give way to a second future vote and have repercussions for future votes on the UK remaining in the EU and general elections in 2015. A “No” vote that fails to win overwhelmingly could potentially accelerate the timing of the referendum for whether the UK remains in the EU.

In terms of financial markets, the closest recent comparable is Canada, which experienced two failed referenda regarding the secession of Quebec in 1980 and 1995. In both instances, markets did not underperform global markets leading into and post the referenda. Although markets shrugged off the referenda, over time many large Canadian corporations relocated their headquarters out of Quebec.

[1] “Is Secession the Answer? The Case of Catalonia, Flanders, and Scotland”, December 2, 2013 retrieved on http://knowledge.wharton.upenn.edu/article/secession-answer-case-catalonia-flanders-scotland/ .

[2] Lukyano Mnyanda, “Scots Anti-Independence Camp Gains in Poll amid Pound Doubts”, August 13, 2014, Bloomberg News.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Investment Insights Podcast – August 13, 2014

Bill Miller, Chief Investment Officer

On this week’s podcast (recorded August 11, 2014):

What we like: Fair amount of correction in the equity markets around the world; small correction also in U.S.

What we don’t like: U.S. stock market will likely correct closer to their 10% before the Fed finishes bond-buying program in October

What we’re doing about it: Hedging more during seasonally-weak time period; mindful of midterm elections

Click the play icon below to launch the audio recording or click here.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Monthly Market and Economic Outlook: August 2014

Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital

After pushing higher for most of July, the U.S. equity markets fell -2% on the last day to end the month in the red. Continued geopolitical concerns, a debt default in Argentina and a higher than expected reading on the Employment Cost Index could have provided a catalyst for the sell-off. Investor sentiment levels were elevated in July, so it is not surprising to have any bad news lead to a short-term pull-back in the equity markets. However, we believe equity markets are biased upward over the next six to twelve months and further weakness could be a buying opportunity.

U.S. small cap stocks have significantly lagged large caps so far this year. In July the small cap Russell 2000 Index declined -6.1%. The Russell 2000 is down -3.1% for the year-to-date period, compared to the +5.5% gain for the Russell 1000 Index. From a style perspective, value lagged growth in July but remains solidly ahead for the year-to-date period.

Developed Europe significantly lagged the U.S. equity markets in July, but Japan was able to deliver a positive return. Emerging markets continued their rally in July, gaining +2.0% for the month. Emerging markets have gained +8.5% through the first seven months of the year, well ahead of developed markets. Countries that struggled in 2013 due to the Fed’s taper talk, like India and Indonesia, have been very strong performers, while negative performance in Russia has weighed on the complex. The U.S. dollar has shown recent strength versus both developed and emerging market currencies.

U.S. Treasury yields edged slightly higher in July. The 10-year yield has fallen 56 basis points from where it began the year (as of 8/7/14), while the 2-year part of the yield curve has moved up eight basis points. As a result, the yield curve has flattened between the 10-year and 2-year tenors; however, it remains steep relative to history. While sluggish economic growth and geopolitical risks could be keeping a ceiling on U.S. rates, relative value could also be a factor. A 2.4% yield on a 10-year U.S. Treasury looks attractive relative to a 0.5% yield on 10-year Japanese government bonds, a 1.1% yield on 10-year German bonds, and a 2.6% yield on Spanish 10-year sovereign debt.

All taxable fixed income sectors were flat to slightly negative on the month. High yield fared the worst, declining -1.3% as spreads widened 50 basis points. Municipal bonds were slightly positive for the month and continue to benefit from a positive technical backdrop with strong demand for tax-free income being met with a lack of new issuance.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, with a number of factors supporting the economy and markets over the intermediate term.

• Global monetary policy remains accommodative: Even with quantitative easing slated to end in the fall, U.S. short-term interest rates should remain near-zero until 2015 if inflation remains contained. The ECB and the Bank of Japan are continuing their monetary easing programs.
• Global growth stable: U.S. growth rebounded in the second quarter. Outside of the U.S., growth has not been very robust, but it is still positive.
• Labor market progress: The recovery in the labor market has been slow but steady. The unemployment rate has fallen to 6.2% and jobless claims have fallen to new lows.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. M&A deal activity has picked up this year. Corporate profits remain at high levels and margins have been resilient.
• Less drag from Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Fiscal drag will not have a major impact on growth in 2014, and the budget deficit has also declined significantly.

Risks facing the economy and markets remain, including:

• Fed Tapering/Tightening: If the Fed continues at the current pace, quantitative easing will end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual and the economy appears to be on more solid footing this time. Should inflation pick up, market participants will shift quickly to concern over the timing of the Fed’s first interest rate hike. Despite the recent uptick in the CPI, the core Personal Consumption Expenditure Price (PCE) Index, the Fed’s preferred inflation measure, is up only +1.5% over the last 12 months.
• Election Year/Seasonality: While we noted there has been some progress in Washington, we could see market volatility pick up later this year in response to the mid-term elections. In addition, August and September tend to be weaker months for the equity markets.
• Geopolitical Risks: The events in the Middle East and Russia could have a transitory impact on markets.

Risk assets should continue to perform over the intermediate term as we expect continued economic growth; however, we could see increased volatility and a shallow correction as markets digest the end of the Federal Reserve’s quantitative easing program. Economic data, especially inflation data, will be watched closely for signs that could lead the Fed to tighten monetary policy earlier than expected. Equity market valuations look elevated, but not overly rich relative to history, and maybe even reasonable when considering the level of interest rates and inflation. Investor sentiment, while down from excessive optimism territory, is still elevated, but the market trend remains positive. In addition, credit conditions still provide a positive backdrop for the markets.

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Source: Brinker Capital

Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index

An End to Complacency

Joe Preisser, Portfolio Specialist, Brinker Capital

Volatility abruptly made an entrance onto the global stage, shoving aside the complacency that has reigned over the world’s equity markets this year as they have marched steadily from record high to record high. Asset prices were driven sharply lower last week, as gathering concerns that the Federal Reserve Bank of the United States may be closer than anticipated to raising interest rates, combined with increasing worries about the possibility of deflation in the Eurozone, and a default by the nation of Argentina, to weigh heavily on investor sentiment. The selling seen across equity markets last Thursday was particularly emphatic, with declining stocks listed on the NYSE outpacing those advancing by a ratio of 10:1, and the Chicago Board Options Exchange Volatility Index (VIX), which measures expected market volatility, climbing 25% to its highest point in four months, all combining to erase the entirety of the gains in the Dow Jones Industrial Average for the year.

The looming specter of the termination of the Federal Reserve’s bond-buying program, which is scheduled for October, is beginning to cast its shadow over the marketplace as this impending reality, coupled with fears that the Central Bank will be forced to raise interest rates earlier than expected, has served to raise concerns. Evidence of this could be found last Wednesday, where, on a day that saw a report of Gross Domestic Product in the United States that far exceeded expectations, growing last quarter at an annualized pace of 4%, vs. the 2.1% contraction seen during the first three months of the year, and a policy statement from the Federal Reserve which relayed that, “short-term rates will stay low for a considerable time after the asset purchase program ends” (Wall Street Journal) equity markets could only muster a tepid response. It was the dissenting voice of Philadelphia Fed President, Charles Plosser who opined that, “the guidance on interest rates wasn’t appropriate given the considerable economic progress officials had already witnessed” (Wall Street Journal), which seemed to resonate the loudest among investors, giving them pause that this may be a signal of deeper differences beginning to emerge within the Federal Open Market Committee. Concern was further heightened on Thursday morning of last week, when a report of the Employment Cost Index revealed an unexpected increase to 0.7% for the second quarter vs. a 0.3% rise for the first quarter (New York Times), which stoked nascent fears of inflation, bolstering the case for the possibility of a more rapid increase in rates.

Negative sentiment weighed heavily on equity markets outside of the U.S. as well last week, as the possibility of deflationary pressures taking hold across the nations of Europe’s Monetary Union, combined with ongoing concerns over the situation in Ukraine and the second default in thirteen years by Argentina on its debt to unsettle market participants. According to the Wall Street Journal, “Euro-zone inflation increased at an annual rate of just 0.4% in July, having risen by 0.5% the month before. In July 2013 the rate was 1.6%” While a fall in prices certainly can be beneficial to consumers, it is when a negative spiral occurs, as a result of a steep decline, to the point where consumption is constrained, that it becomes problematic. Once these forces begin to take hold, it can be quite difficult to reverse them, which explains the concern it is currently generating among investors. The continued uncertainty around the fallout from the latest round of sanctions imposed on Russia, as a result of the ongoing conflict in Ukraine, further undermined confidence in stocks listed across the Continent and contributed to the selling pressure.

Into this myriad of challenges facing the global marketplace came news of a default by Argentina, after the country missed a $539 interest payment, marking the second time in thirteen years they have failed to honor portions of their sovereign debt obligations. The head of research at Banctrust & Co. was quoted by Bloomberg News, “the full consequences of default are not predictable, but they certainly are not positive. The economy, already headed for its first annual contraction since 2002 with inflation estimated at 40 percent, will suffer in a default scenario as Argentines scrambling for dollars cause the peso to weaken and activity to slump.”

With all of the uncertainty currently swirling in these, “dog days of summer,” it is possible that the declines we have seen of late may be emblematic of an increase in volatility in the weeks to come as we move ever closer to the fall, and the terminus of the Fed’s asset purchases.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Investment Insights Podcast – July 25, 2014

Bill Miller, Chief Investment Officer

On this week’s podcast (recorded July 23, 2014), we alter the format to provide commentary on a recent publication from the Ned Davis Research Group.

The article references an old adage that when the public gets in the stock market, it’s too late. While that’s a bit cynical, the public is not always wrong. Recently, the bond market seems to show that over the past five years, the public is pretty smart. Here are some additional takeaways:

• The allocation to stocks is on the high side, but not excessive
• Cash allocation seems low
• Flows into equities and bonds have been good

This, and other measures, lends itself to believe that the public is in (the market), but not excessively in. However, are they in because they want to be in or because the have to be in? The Fed’s zero interest rate policy seems to drive behavior of investors towards stocks–creating a feeling that the public is not in.

The takeaway is that we have to be mindful if the allocations get too big. A defense for that is diversification across different asset classes.

Click the play icon below to launch the audio recording or click here.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Update on Impact of Russia/Ukraine Conflict on Financial Markets

Stuart P. Quint, CFA, Senior Investment Manager and International Strategist

A past blog in March had commented on several scenarios of how the unrest in Ukraine could play out and the potential implications of those scenarios on financial assets.  Given the crash of the Malaysian airliner over Ukraine, an update seems appropriate.

We remain of the view that the conflict in Ukraine should have a limited impact but likely a longer timeframe to play out, potentially with risks to the downside.  Downside risks would materialize in the event of an overt Russian invasion or further separatist activity in other parts of Ukraine.

We mentioned 3 areas of potential impact: (1) fixed income, (2) commodity prices (particularly energy), and (3) emerging markets.  European equities could also be affected if tensions were to spiral and/or more serious economic sanctions were taken.

Fixed income (as measured by the Barclay’s Aggregate Total Return Index) has rallied nearly 2% since that time.  One factor in the continued rally might stem from risk aversion driven by geopolitical tensions.  However, fixed income has lagged the rally in riskier asset classes such as domestic and international equities.

Energy has staged a modest gain from March to July in spite of ongoing tensions between Russia and Ukraine.  This modest impact comes in spite of not only Russian tension, but also ethnic tensions in Israel and Iraq, also a major oil producer.  Energy markets have been complacent about rising supply sources from elsewhere, including the United States, along with muted demand from many emerging markets and Europe.  Any increase in political tensions along with improved economic growth in the US and more energy-intensive emerging markets could presage an increase in energy prices.

Gold, another traditional safe harbor asset, has actually declined over -2% over this time period.

Emerging market equities have rallied strongly (over +12% during this time period), though Russian equities lagged this gain.  Select continental European equity markets such as Germany and France have been flat and lagged performance of other equity markets, suggesting a slight negative impact from uncertainty in Ukraine.

Barring a major spiraling in tensions, we would expect economic and market fundamentals to be the overwhelming drivers of asset performance rather than geopolitical tensions out of Ukraine.

 

Investment Insights Podcast – July 18, 2014

Bill Miller, Chief Investment Officer

On this week’s podcast (recorded July 16, 2014) the subject matter pertains to the Congressional Budget Office’s release of their long-term outlook. It’s important to note that this forecast is a 75-year time horizon; so focus should be on the near-term debate in Washington:

What we like: Raised the long-term growth rate of the economy; lowered healthcare costs and interest rate costs which is a positive in the near term

What we don’t like: Healthcare and interest rate costs in the long term; interest rates likely to rise eventually; Social Security likely to rise in the near future; defense spending cutbacks

What we are doing about it: As citizens, being thoughtful when exercising the right to vote; keeping an eye on higher interest rates and impact on fixed income

Click the play icon below to launch the audio recording or click here.

Source: CNBC

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Monthly Market and Economic Outlook: July 2014

Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital

Equity markets continued to grind higher in the second quarter despite continued tapering by the Federal Reserve, a negative GDP print, and rising geopolitical tensions. All asset classes have delivered positive returns in the first half of the year, led by long-term U.S. Treasury bonds. There has been a lack of volatility across all asset classes; the CBOE Volatility Index (VIX) fell to its lowest level since February 2007.

Year to date the U.S. equity markets are slightly ahead of international markets. All S&P sectors are positive year to date, led by utilities and energy. Mid cap value has been the best performing style, helped by the double-digit performance of REITs. U.S. large caps have outperformed small caps, but after experiencing a drop of more than -9%, small caps rebounded nicely in June. Value leads growth across all market capitalizations.

Despite concerns surrounding the impact of Fed tapering on emerging economies, emerging market equities outperformed developed markets in the second quarter, and have gained more than 6% so far this year, putting the asset class ahead of developed international equities. Small cap emerging markets and frontier markets have had even stronger performance. The dispersion of performance within emerging markets has been high, with India, Indonesia and Argentina among the top performers, and China, Mexico and Chile among the laggards. On the developed side, performance from Japan has been disappointing but a decent rebound in June bumped it into positive territory for the year-to-date period.

Despite a consensus call for higher interest rates in 2014, U.S. Treasury yields moved lower. The 10-year Treasury Note is currently trading at 2.6% (as of 7/7/14), still below the 3.0% level where it started the year. While sluggish economic growth and geopolitical risks could be keeping a ceiling on U.S. rates, technical factors are also to blame. The supply of Treasuries has been lower due to the decline in the budget deficit, and the Fed remains a large purchaser, even with tapering in effect. At the same time demand has increased from both institutions that need to rebalance back to fixed income after experiencing strong equity markets returns, and investors seeking relative value with extremely low interest rates in Japan and Europe.

With the decline in interest rates and investor risk appetite for credit still strong, the fixed income asset class has delivered solid returns so far this year. Both investment grade and high yield credit spreads continue to grind tighter. Emerging market bonds, both sovereign and corporate, have also experienced a nice rebound after a tough 2013. Municipal bonds benefited from a positive technical backdrop with strong demand for tax-free income being met with a lack of new issuance.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, with a number of factors supporting the economy and markets over the intermediate term.

• Global monetary policy remains accommodative: Even with quantitative easing slated to end in the fall, U.S. short-term interest rates should remain near-zero until 2015 if inflation remains contained. The ECB and the Bank of Japan are continuing their monetary easing programs.
• Global growth stable: We expect a rebound in U.S. growth in the second quarter after the polar vortex helped to contribute to a decline in economic output in the first quarter. Outside of the U.S., growth has not been very robust, but it is still positive.
• Labor market progress: The recovery in the labor market has been slow, but we have continued to add jobs. The unemployment rate has fallen to 6.1%.
• U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. M&A deal activity has picked up this year. Corporate profits remain at high levels and margins have been resilient.
• Less Drag from Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Fiscal drag will not have a major impact on growth in 2014, and the budget deficit has also declined significantly.

Risks facing the economy and markets remain, including:

• Fed Tapering/Tightening: If the Fed continues at the current pace, quantitative easing will end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual and the economy appears to be on more solid footing this time. Should inflation pick up, market participants will shift quickly to concern over the timing of the Fed’s first interest rate hike. Despite the recent uptick in the CPI, the core Personal Consumption Expenditure Price Index (PCE), the Fed’s preferred inflation measure, is up only +1.5% over the last 12 months.
• Election Year: While we noted there has been some progress in Washington, we could see market volatility pick up later this year in response to the mid-term elections.
• Geopolitical Risks: The events surrounding Iraq, as well as Russia/Ukraine are further evidence that geopolitical risks cannot be ignored.

Risk assets should continue to perform if we experience the expected pickup in economic growth; however, we could see increased volatility and a shallow correction as markets digest the end of the Federal Reserve’s quantitative easing program. Economic data, especially inflation data, will be watched closely for signs that could lead the Fed to tighten monetary policy earlier than expected. Equity market valuations look elevated, but not overly rich relative to history, and maybe even reasonable when considering the level of interest rates and inflation. Investor sentiment remains overly optimistic, but the market trend remains positive. In addition, credit conditions still provide a positive backdrop for the markets.

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class	Outlook	Favored Sub-Asset Classes
U.S. Equity	+	Large cap bias, dividend growers
Intl Equity	+	Emerging and Frontier markets, small cap
Fixed Income	–	Global high yield credit, short duration
Absolute Return	+	Closed-end funds, event driven
Real Assets	+/-	MLPs, natural resources equities
Private Equity	+	Diversified

 

Source: Brinker Capital

Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index.

Investment Insights Podcast – July 1, 2014

Bill Miller, Chief Investment Officer

On this week’s podcast (recorded June 30, 2014), Bill addresses some of the things we don’t like first, then gives greater insight into what we are doing about it:

What we don’t like: Interest rates are stubbornly low; expectations were that they would rise over the first-half of the year; low interest rates hurt retirees ability to generate income

What we like: How we are handling this financial repression

What we are doing about it: Emphasizing three themes in fixed income: yield, shorter maturity bonds, and inclusion of absolute return

Click the play icon below to launch the audio recording or click here

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Investment Insights Podcast – June 26, 2014

Bill Miller, Chief Investment Officer

On this week’s podcast (recorded June 19, 2014):

What we like: A string of good economic news; earnings season looks strong; expectations rising; Fed tapering showing that they are being reasonable about their exit

What we don’t like: Fed seems to be ignoring the increased inflation

What we are doing about it: Emphasis on real assets; watchful of a summer correction.

Click the play icon below to launch the audio recording or click here.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.