Global risk markets have been exuberant lately, expecting U.S. consumers to accelerate their spending even further, U.S. interest rates to remain low and Brexit to have little impact on the global economy. However, although the market never expected an economic or political disaster from Brexit, there is good reason to be cautious about the intermediate-term outlook.
It has never been correct to be an intense euro-skeptic, but while the eurozone should remain intact and no other country will likely leave the EU, a tumultuous period clearly lies ahead. (The U.K.'s situation is unique, and the trauma of exiting would be too great for the majority of any other EU member's voters to approve).
In the short run, hopes that Brexit will not eventuate, or that the EU will compromise on an easy and advantageous solution, are likely to be dashed fairly soon, as the EU wishes to quickly scare off other countries and seeks the U.K.'s financial services industries to be shifted to the Continent, including the regulation of clearing of euro-securities. Indeed, the EU could well push the U.K. to declare its formal exit much sooner than expected, likely early in the fourth quarter, via various regulatory measures and threats that any delays will force an even tougher negotiating stance.
Major economies already were relatively slow before the Brexit vote and are likely to slow further. Nearly all major economists have lowered their global forecasts to some degree. The U.K. is likely to enter recession fairly soon, and as it is continental Europe's largest export market, this, along with Brexit and other EU political uncertainties soon approaching, should significantly lower economic growth there too, although likely skirting a recession. By the way, the EU's economy is 20% larger than the U.S. economy. Thus, major central banks likely will be on hold or ease further at least for the rest of this year and bond yields should end the year around recent lows. Commodity prices should erase their recent rebound as global growth slows. Slower global economic growth and lower commodity prices should hurt the corporate profit outlook despite lower interest rates.
The prospects for U.S. elections will also be key to market sentiment in the coming months. The U.S. is not the U.K., but there are undeniable political-trend similarities, with the effect of another surprise being vast. Indeed, the Brexit outcome seems to boost Donald Trump's chances to be elected president, but if the U.K. economy and markets, including real estate, decline substantially, such would actually detract from his cause. Investors will be very wary of U.S. polls and betting odds, so uncertainty will increase further, and the fact that both major presidential candidates are to some degree anti-big business and anti-Wall Street, coupled with populist views against current global trade and corporate tax regimes, confidence in the U.S. corporate profit outlook should decline. Interestingly, outside of the U.S., the region with the greatest overall stability ahead is Japan because it maintained a highly egalitarian public policy and restricted immigration to high-income earners.
If Brexit had hit when U.S. equities valuations were more reasonable, investors would not need to be as cautious, but the market is very expensive and is trading more on dividend yield than the price-earnings ratios. With falling bond yields, the attraction of dividend yields should remain to some degree, but the rationale of this kind of investing depends (except for the most defensive sectors) greatly on the prospect of future earnings and global risk sentiment. Buying just for an additional one percentage point of return from dividend yields over bond yields will not seem too advantageous if equity prices decline 10%.
There are real questions about the durability of dividend yield investing, except for investors with a multiyear outlook. The Standard & Poor's 500 is now trading above 18 times 2016 consensus earnings and if one fully expenses for option grants, the p/e ratio is probably a full point higher. Based upon what accountants say is “true profit,” which removes all the profit adjustments made by companies, the 2016 p/e ratio is likely well above 20. Given this, a moderate decline in the p/e ratio is likely, due to lower global economic growth prospects, corporate profit outlook (especially with the stronger U.S. dollar since Brexit) and reduced risk appetite.
Beyond EU politics and the U.S. election, investors must also note that serious geopolitical risks abound. These factors should drive the S&P 500 below 2000 by year-end, and Japan and Europe should not fare much better. Clearly, investors should not expect a major crisis, but if an irrational global bubble develops based on negative interest rates and the ignorance of risks, the eventual downside risks will likely be long-lasting and painful. n
John Vail is chief global strategist and chairman of the global investment committee of Nikko Asset Management Americas Inc., New York.
