Brexit and the feedback of uncertainty through asset prices

The medium- and long-run consequences of Brexit are unknown, but increased uncertainty in response to the event will likely have real global effects of its own. Individuals are now less confident in their guesses about the future, and this uncertainty changes behavior, increasing risk aversion and decreasing business investment. Global markets reaction to Brexit reflects not only the new average belief about expected future earnings, but also the indirect feedback effects of the higher level of uncertainty.

Medium- and long-term effects unclear

The U.K.’s June 23 vote to leave the European Union, termed ‘Brexit’, surprised many analysts. As the referendum vote neared, markets (representing the average belief of individuals) increasingly expected the ‘remain’ party to win. Some well-educated analysts explained how Brexit would never happen (possibly what Nassim Nicholas Taleb would consider proof of a black swan). The ‘leave’ campaign won with 51.9 percent of the vote, prompting David Cameron’s announced resignation.

The medium-term consequences for the U.K. and E.U. (or anywhere else) are entirely unclear. For example, should unemployment increase and production falter in the U.K. during the next few months, the Bank of England may need to ease monetary policy further and adopt very unconventional tools. However, if the market reaction to Brexit can be fully absorbed by exchange rate adjustment, the Bank of England may need to raise interest rates in response.

On June 24, the pound sterling fell more than eight percent against the dollar (figure 1). In response to the currency depreciation, many here in the U.S. joked about buying goods online from the U.K. or planning vacations. Many others expressed uncertainty about the future of the U.K. and the E.U., and the economic and political implications for the U.S.

gbp_jun262016
Figure 1. The pound sterling fell against most currencies following the Brexit vote, including by more than eight percent in one day against the U.S. dollar.

Markets reminded of their anxiety issues

Within hours of the ‘leave’ campaign victory, stock prices of some financial services companies, such as Lloyds, fell by 30 percent. Although real changes from the vote may take two years to implement, the average belief about the appropriate cost of equity for these firms changed dramatically overnight. The fundamentals for people and businesses in the U.K. do not immediately change, but their behavior and asset prices do, and this has an indirect feedback effect on the fundamentals

Likewise, the U.S. is clearly not part of the E.U. or U.K., however, it is intimately linked to both markets through trade and investment. The Dow Jones Industrial Average fell 610 points (3.39%) on Friday in response to the news. The most widely-used measure of market volatility jumped nearly 50 percent (figure 2). The sales revenue of the largest U.S. companies is practically unchanged, however, individuals’ collective behavior has changed in response to uncertainty.

Individuals are repricing the assets that they previously overvalued. However, if the Bank of England is forced to wait to decide which direction its key policy will turn, how well can individuals immediately reprice future earnings? The immediate reaction to Brexit reflects not a new certainty about future earnings but increased uncertainty. Individuals never know what the future will hold, but these large unexpected events make them less confident in all of their guesses, and it changes their behavior.

vix_jun252016
Figure 2. VIX, the CBOE measure of expected near-term equity market volatility, saw an almost 50 percent daily increase following the Brexit result

Searching for safety and the uncertainty feedback loop

When people are less certain about the future, they take fewer risks. For example, business investment falls when equity market volatility is high. Individual and institutional investors also show preference for safe assets during times of increased uncertainty. In an immediate reaction to Brexit, U.S. treasuries, gold, and Japanese Yen saw inflows, while equity markets saw net outflows. Neither business fundamentals nor any rules had changed; people were showing risk aversion.

Investors’ increased aversion to equity investment raises firms’ equity cost of capital. This cost of capital is a major factor in firms’ investment decisions, especially for smaller and less-cash-flush firms. Therefore, the uncertainty induced asset price shock has a feedback mechanism through which it affects the future value of companies. This dangerous feedback mechanism can be procyclical.

What it means for the U.S.

The medium- and long-term direct effects of Brexit on the U.S. are very unclear. Brexit-induced equity market volatility, higher levels of uncertainty, and the negative effects these entail can however be analyzed with attention to the current U.S. macroeconomic environment. Three potential short-run consequences emerge:

1) Continued volatility in equity markets and strong demand for treasuries;

2) More downward pressure on business investment, which was already negative in the first quarter of 2016; and

3) Delay of the next Federal Funds rate hike in response to the above.

While the downward pressure on already weak business investment is worrisome, none of the above are enough to induce major concern. Households, many of which have recently started seeing long-awaited wage and income increases, will play a key role in determining whether recent asset price volatility will spill into consumer sentiment and awake a much worse set of feedback mechanisms.

Check out the dashboard and please leave feedback

Nearly 100 freshly updated charts:

U.S. Macro and Markets Dashboard (Updated June 26, 2016)

References and additional reading

Networks, Crowds, and Markets: Reasoning About a Highly Connected World by David Easley and Jon Kleinberg

Nick Bloom comment on Brexit 

BBC: The UK’s EU referendum: All you need to know

 

Dashboard update: consumer-side improvement and other reasons not to worry

Dashboard PDF file:

Macro and Markets Dashboard: United States (May 14, 2016)
Dashboard Update Summary

Surprisingly good April retail sales growth and preliminary signs of strong May consumer sentiment suggest a continued strengthening of consumer spending. Higher wages and low but rising inflation expectations boost individuals’ willingness to make discretionary purchases. Recent quarterly earnings data suggest that these purchases are increasingly taking place through Amazon and online retailers rather than department stores. Equities were lower over the past five trading days, partially as a result of poor earnings data from the latter. Jobless claims increased in the first week of May, but remain within a reasonable range. The yield curve flattened during the week as the spread between ten-year treasury bonds and three-month t-notes fell to its lowest level since February. The dollar appreciated against most major currencies.

Consumer sentiment and spending rising

Retail sales excluding food increased year over year by 2.7 percent in April. This is the second largest increase since January 2015 (the largest in the past 15 months was in February). In April, Retails sales overall were up three percent over the previous year and up a surprising 1.3 percent over the previous month. Many online retailers, including Amazon, had their strongest-ever quarter in Q1. Meanwhile, this week’s earnings releases from Nordstrom, Kohl’s, and Macy’s shows a continuation in consumers’ pivot away from U.S. department stores. U.S. equities closed lower on the week, with the S&P down half a percent, the Nasdaq down 0.4 percent, and the Dow down 1.2 percent.

retailsales_may132016

Prices remain low with some hills on the horizon

The uptick in retail sales can be attributed in part to higher wages for consumers, as evidenced in recent labor market data. Additionally, fuel prices remain low, yet there is some sign that movement is towards increasing price levels, which incentivizes spending today, especially given a very low return on savings. The April producer price index (PPI), which measures how prices of the inputs to production change, was released this week. The PPI for all commodities (intermediate demand) increased to a -4 percent year over year change, from -4.8. Energy prices fell less dramatically in the twelve month period ending in April. Oil prices climbed 3.5 percent during the past week, but remain below $50 a barrel, at $46.21.

ppiaco_may132016

Jobless claims rise

The number of new jobless claims during the week of May 7 was higher at 294,000. While the highest level of new jobless claims since February of 2015 may seem startling, the level is still low and the increasing bargaining power of labor makes voluntarily leaving a job less scary.

weeklyjobless_may132016

Yield curve flattens as foreign investors avoid negative yields

Another potentially startling indicator is the flattening of treasury yield curves, but again, there is an explanation to assuage concern. The yield spread between ten-year treasuries their three-month t-bill counterpart fell to 1.43 on Friday, from 1.6 a week earlier, as ten-year yields fell and three-month yields rose. Likewise, the spread between ten- and two-year treasuries fell. While this indicator is a potential bad omen, we must remember that foreign inflows to treasury auctions have been increased by negative interest rates in many EU countries and Japan. For example, as ten-year Japanese Government Bond yields remain negative, Japanese investors increasingly shift portfolios to the U.S. government equivalent.

yieldspread_may132016

Dollar appreciates against trading partners

Lastly, the U.S. dollar was stronger against most major currencies during the past week. The dollar appreciated by 1.4 percent against the Yen, by 3.5 percent against the Rand, by 0.85 percent against the Euro, and by half a percent against the British Pound.

I’ve redesigned the exchange rates table to be quicker to read, and include it below.

fx_may132016
Rates above as of May 13, 2016

dash_open

 

Dashboard update: Jobs data and new uncertainty

Dashboard PDF file:

Macro and Markets Dashboard: United States (May 7, 2016 — PDF)
Dashboard Update Summary:

Jobs data for April showed payrolls continue to grow, but at a slower rate. Wage data was strong, however, the labor force participation rate gave up much of its recent improvement. Uncertainty surrounding markets and economic policy seems to have increased in the recent week, and fewer economists now predict a Fed rate hike in June. U.S. equity markets were down for the second consecutive week, while corporate bond yields rose and treasury yields fell. Recent data showed improvement in the trade balance from the weaker dollar, however, the recent depreciation trend has also become less certain.

Jobs Report showed slower jobs growth but wage improvement

The U.S. added 160,000 jobs in April, compared with 208,000 in March and 233,000 in February (both previous months were also revised downward). By sector, much of the growth came from the services side, on an annualized basis. Construction jobs, which make up less than five percent of nonfarm payrolls, were up 4.1 percent, while mining and logging jobs continued their decline and are now down more than fifteen percent over the past year (this is the smallest industry sector shown in the figure below, and represents only 0.4 percent of nonfarm payrolls). Weekly data on new jobless claims, as of April 30, showed still very low, but slightly increased, levels.

jobsector_may072016

The latest jobs report shows continued improvement in both nominal and real wages in practically all sectors. Nominal wages increased most rapidly over the past year in financial services, information services, and leisure and hospitality. On average, wages from the goods sector are higher, largely as a result of low-wage service-sector jobs in leisure and hospitality.

wages_may072016

Equity and Bond market conditions deteriorated

Equity markets were down for the second straight week. The S&P 500 was down 0.4 percent, the Nasdaq composite index was down 0.8 percent, and the Dow Jones industrial average was 0.2 percent lower. Volatility was higher during the week, and the VIX closed Friday at 14.7. The Shiller index of price to earnings ratios was up to 26.02 percent in April from 25.54 in March. Corporate bond yields ticked up during the week. The Merrill Lynch index of junk bond yields was up to 7.56 percent. Ten year treasury yields fell to 1.79 percent.

Economic policy uncertainty improved in April but may revert

Economic policy uncertainty, as measured by Baker, Bloom, and Davis, fell sharply in April, as there was little speculation of Fed action at the April meeting. However, I expect this index to bounce back; uncertainty will increase as the Fed June meeting and Brexit grow closer.

epu_may072016

Oil was down on the week, while April food prices increased

Oil prices closed lower on the week. The U.S. measure of crude oil prices, West Texas Intermediate crude front-month contracts, fell 2.7 percent during the week, to $44.66 a barrel. World food prices from the Food and Agriculture Organization (which I half-jokingly also use as a proxy of political instability) ticked up slightly in April, but remain low.

A weaker dollar improved the trade balance in March

The Fed’s trade-weighted dollar broad index against major currencies fell last Friday (April 29–past week data is released on Mondays) to its lowest level since May 2015. The year-to-date rapid depreciation of the dollar has cut import quantities, as further evidenced in the March data on trade. The trade deficit, which remains roughly 2.2 percent of GDP, improved to -40.4B in March. However, more recent foreign exchange data shows uncertainty about recent depreciation trends. The dollar was stronger against nearly all major trading partners during the past week, notably 1.2 percent against the British pound, 2.76 percent against the Canadian dollar, 3.16 percent against the Australian dollar, 4.5 percent against the Turkish lira, 3,86 percent against the Mexican peso, and 4.3 percent against the South African rand.

tb_may072016

Dashboard update: lowered expectations

Dashboard PDF file:

Macro and Markets Dashboard: United States (April 16, 2016 — PDF)

Dashboard update summary:

Much of the past week’s macroeconomic news offered disappointment, yet markets dismissed the weak data as a result of what seems like lowered expectations. Retail sales, business inventories, and industrial production reports showed weakness in March (though labor market continues to look good). Corporate earnings have been quite soft in the first quarter, and GDP figures are likely to reflect the first quarter slowdown in output. Investors, however, seem relatively more risk-on, despite the weak macroeconomic data. Their expectations about earnings have fallen low enough to not only absorb the recent results, but to react positively in some cases. These investors are also faced with fewer high-earning alternatives, given sluggish and slowing growth abroad.

CPI and PPI data show little change, while oil prices continue to rebound. Currency markets are quite active, especially on the emerging markets side, where the dollar is weaker, partially as a result of the commodity price rebound.

Macro and Labor Market Indicators

Industrial production and total capacity utilization both fell in March. The industrial production index was down 0.6 points, largely stemming from decreases in production in mining and utilities market groups. This was magnified in the total percentage of capacity utilized figure, which fell to its lowest level since 2010. Mining capacity grew 1.6 percent year over year, despite a simultaneous 12.9 percent fall in production.

tcu_apr162016

The inventories to sales ratio ticked up in February, as a result of a fall in sales of 1.4 percent and an increase of inventories by 1.2 percent over their February 2015 levels. The most recent week’s data on new jobless claims showed the fewest new claims since 1973.

Equities and Fixed Income

Despite the weak data from the corporate side, equity markets were up and corporate bond yields down during the week. The Nasdaq and Dow were up 1.8 percent on the week, while the S&P 500 climbed 1.6 percent. Yields on U.S. Treasury bonds at all maturities, and U.S. corporate bonds at all maturities and credit ratings, have fallen over the past month, pushing prices higher.

Prices and Currency Markets

This week brought the release of March PPI and CPI data. Both were largely unchanged, as the PPI for all commodities increased slightly and the CPI fell slightly, over their February year over year percentage change levels. There was a surprise in CPI apparel prices, which fell 0.6 percent over their March 2015 levels, despite an increase in February. The data continue to reflect the very low prices of energy and moderate prices increase in healthcare and housing.

prices_apr162016

Currency markets were busy during the past week. The dollar strengthened against the Euro (0.91 percent), Yen (0.81 percent), and Swiss Franc (1.06 percent), while, as pointed out by FT’s hard currency, the dollar weakened further against the four R’s, the ruble, real, ringgit, and rand. These four currencies have seen a dramatic change in direction over the past month, appreciating against the dollar by more than 3.5 percent each and more than 5 percent in the case of the rand.

Note:

I try to gradually improve the dashboard and how I summarize changes. Any feedback would be much appreciated. Please feel free to leave a comment, or send me an email at brianwdew@gmail.com.

Dashboard update: signs of price pressure

Macro and Markets Dashboard: United States (April 9, 2016 — PDF)

The first full week of April saw active but net slightly down equity markets. While new economic data during the week was positive, expectations about corporate profits and output levels in the first quarter of 2016 are low. In light of solid fundamentals, and increasing aggregate demand, pessimists (including on the campaign trail) seem to be overreacting. Price data shows signs of upward pressure after an extended decline, and may soon join labor market and equity market indicators in signalling accelerating economic expansion.

The Nasdaq composite index fell 1.3 percent on the week, while both the S&P 500 and the Dow Jones Industrial Average fell 1.2 percent. Volatility, as measured by the VIX, closed Friday 17 percent above its previous week level. The Shiller index of price to earnings ratios climbed in March to 25.5. Expectations about first quarter earnings are very weak.

pe_apr092016

Prices data showed a continuation of upward pressure in March from commodity and food prices. Oil prices climbed more than eight percent during the past week. U.S. oil inventory fell for the first time in eight weeks. March CPI data, due out next week, should reflect the rising fuel and commodity prices.

wti_apr092016

World food prices, measured by the Food and Agriculture Organization of the UN, showed an uptick in March from a jump in sugar prices. This is only the second material increase in the world food price index since early 2014.

ffpi_apr092016

The trade-weighted dollar index continues to show a depreciation in the U.S. dollar. To the frustration of the Bank of Japan, the Yen appreciated nearly three percent against the dollar during the past week, which is not included in the lagged trade-weighted index. The dollar did appreciate against many emerging market currencies, pound sterling, and the Canadian dollar, during the past week.

fx_apr092016

Dashboard update: recent economic data

Macro and Markets Dashboard: United States (March 19, 2016 — PDF)

As expected, the Fed left key interest rates unchanged. New economic data covering prices, industrial production, jobless claims, and inventories did not offer any dramatic surprises. Equity markets were up on the week, while treasury bond yields fell. The dollar weakened against nearly all major currencies.

Markets reacted positively to the Fed’s key interest rate decision and reduction of their forecast for 2016 rate hikes to two from four. The Nasdaq composite index increased one percent on the week, while the S&P 500 climbed 1.35 percent. Ten-year treasury bond yields fell to 1.88 percent on Friday.

Monthly CPI figures for February showed a year over year consumer price level increase of one percent, compared with a 1.3 percent increase in January. Energy and transportation costs fell more in February than January. Energy costs dropped 12.7 percent over their February 2015 level, while transportation costs fell 3.6 percent over the one-year period.  Healthcare, food, housing, and apparel prices all increased over the previous year’s level. Healthcare costs were up 3.5 percent.

cpi_mar192016

The industrial production index and total capacity utilization figures were both down slightly in February, following a modest increase in January.

iptcu_mar192016

New weekly jobless claims, at 265,000, showed no sudden increase, further supporting the so far solid labor market data. January data on manufacturing and trade inventories and sales, from the U.S. Census Bureau, showed that sales were down 1.1 percent over their January 2015 level, while inventories were up 1.8 percent over the same period, pushing the inventories to sales ratio to 1.4.

jobinv_mar192016

Over the past week, the U.S. dollar weakened against all major currencies except for the Egyptian pound, which was devalued by 14 percent against the dollar during the week. The dollar fell roughly two percent or a bit more against the Euro, Yen, and Canadian Dollar, and nearly a percent and a half against Pound Sterling and Swiss Francs. The dollar fell against the Yuan by nearly three quarters of a percent on Friday.

fx_mar192016

 

 

Dashboard update: data marches forward

Macro and Markets Dashboard: United States (March 5, 2016 — PDF)

This week brought more strong labor market data and more relief for commodity markets. Equity markets were also up on the week, while treasury and high-grade bond yields remain low. Decomposition of broad equity market growth shows that investors are still risk-off. Value stocks have climbed while riskier investments still seem reasonably priced, providing additional evidence that risk aversion persists.

February jobs data showed continued tightening of U.S. labor markets. The unemployment rate remains 4.9 percent while the labor force participation rate increased by two tenths of a percent to 62.9, a one-year high.

CIVPART_mar052016

The S&P 500 closed on Friday at 1999.99, as if priced by a nineties consumer psychologist. The index climbed 2.7 percent during the week. A crude decomposition shows value opportunities favored over growth opportunities so far in 2016. Year-to-date, the S&P 500 Growth ETF is down 3.03 percent, while the S&P 500 Value ETF is down only 0.37 percent.

SP500_mar052016

Meanwhile, treasury bond yields remain very low. The real yield curve rate on a five year U.S. treasury bond was negative on Thursday, at -0.03%, and closed Friday at 0.02%. People are willing to sacrifice returns for the relative safety of government debt. Japan issued new ten year bonds with a negative yield for the first time this week. Investors clearly do expect the markets to adjust so that these safe assets provide some future positive yield, but are willing to pay the government of Japan for short-term security.

FiveYrReal_mar052016

While equity and commodity markets have become gradually less volatile over the past two weeks, foreign exchange markets continue to move in all directions, reflecting both stories–commodities relief and risk aversion. I’ve pasted below the full table from my dashboard. Over the past week, the dollar returned some of the previous week’s gains against the pound, but continued to strengthen against the euro and yen. Notably, the Brazilian real strengthened four percent against the dollar during the past week.

EXR_mar052016

 

Dashboard update: noisy week

Macro and Markets Dashboard: United States (February 6, 2016 — PDF)

Modest U.S. macroeconomic data continues to pour in, yet equity markets tumbled, possibly pricing in a steeper trajectory for the fed funds rate. JP Morgan Funds’ chief strategist, David Kelly noted in his weekly podcast that the noisy week was “unlikely to resolve issues troubling markets”.

Yesterday’s jobs report showed an increase in non-farm payrolls of 151,000 workers, bringing the unemployment rate down to 4.9%. The number of long-term unemployed was basically unchanged. The civilian labor force participation rate improved by a tenth of a percent to 62.7. Wages also improved slightly; average hourly earnings are 2.5 percent higher than a year ago.

unemp_Jan_2016

A new note from Francisco Blanch of Bank of America Merrill Lynch reminded that the oil price collapse generates an enormous wealth transfer from oil producers to consumers. Over time, this type of transfer may show up in personal savings rate or personal consumption expenditure data, however, the December personal savings rate was unchanged at 5.5 percent.

January manufacturing PMI data was practically unchanged at 48.2, however the index of non-manufacturing business activity fell more than 9 percent to 53.9.

nmi_Jan_2016

Major U.S. equity market indicators were down on the week, and tech stocks were hit particularly hard on Friday. The S&P 500 was down more than three percent during the week, and the Nasdaq composite index dropped more than five percent. Oil, as measured by front month contracts of WTI, closed Friday at $30.89 a barrel.

The dollar depreciated against most major currencies during the week, providing some relief for U.S. exporters (and policymakers). The dollar weakened more than four percent against the Brazilian Real, more than three percent against the New Zealand Dollar, and more than two percent against the Euro, Yen, Canadian Dollar, and Swiss Franc. The dollar was down roughly 1.7 percent against sterling.