This is the big point we think. The UK faces deep uncertainty whereas the threat to Europe, or more precisely the EU, is existential. Does the UK have the skilled politicians to navigate through what will be a period of deep uncertainty? Only time will tell. However, the greater threat by far now is to the EU. We have said this previously but we’ll say it again. To survive the EU has to move towards full political, fiscal and banking Union – the current status quo will not last for long. The opposite direction of travel is towards a smaller or perhaps two speed Europe, or a full break-up of the EU and a move back to individual sovereign states hopefully within a trade zone. With so many uncertainties, nobody can know precisely what the future holds.

So, although we can speculate about the future and try and work out optimal strategies for all eventualities, the situation is going to be fluid. As such, we think a flexible strategy will be required in the weeks and months ahead. However, we do think that the massive uncertainty that Brexit will cause will require increased risk premiums and therefore lower prices for many financial assets and potentially a bid in some traditional safe haven assets.

After such a big shock, it takes time for markets to fully react and even longer for big investors to make changes to reflect the new world that we now live in. Although we expect lower prices ahead for equities, corporate bonds and other assets like emerging markets and currencies, it may take longer than the bearish community expect. Central banks are ready to step in and smooth the price discovery process and this may well delay the onset of lower markets. However, the odds of a nasty bear market and global recession have increased sharply.

Perhaps the best case scenario is that central banks flood the system with liquidity, markets stabilise and politicians pull a rabbit out of the hat and suddenly find the recipe for robust economic growth and social cohesion. We are not hopeful however. We have been arguing for some time that central banks are beginning to lose credibility and European and Japanese equity markets have hardly been big beneficiaries of negative interest rates and QE. Even if markets do stabilise for a period of time, we just don’t see politicians as magicians.

Mainstream politicians crave the status quo. Sudden change that is outside of their control is something they simply do not like, and their gut reaction is to try and move back to the previous status quo. However, as noted above, we simply do not believe that the status quo can be maintained in Europe. Frankly, we expect European politicians, weakened as they are by structural problems and fighting difficult domestic battles, to fail to get ahead of the problems. The existential threat to Europe that the FT talks about is, in our opinion, likely to lead to a much different, less cohesive Europe.

Looking further afield, the risk to Emerging Markets has also increased. Less global growth and lower commodity prices are headwinds that we discussed quite a few times in the last 18 months. Perhaps the biggest risk is a strong US Dollar as those that have borrowed in Dollars scramble to buy to cover both debt service costs and perhaps to repay capital or convert to local currency (at higher rates though).

The 800lb gorilla in this sphere is China, and although most of their recent borrowing binge has been in local currency rather than Dollars, there is a real risk of capital flight if their economy slows as we expect. A weaker Yuan as part of a globally strong Dollar will “export” China’s deflation to the US and the rest of the World; a similar but perhaps more dramatic episode than that seen in the second half of last year.

So, the fundamental situation is simply not looking good, and although we may be underestimating the skill of the political and financial elites, the risks are very real. If our bearish fundamental picture is anywhere near right, then this will be compounded by the current elevated valuations in financial markets. Central banks have pumped up financial markets after years of zero or negative interest rates and trillions of Dollars of QE, and if the global economy suffers the shock we envisage, valuations need to adjust a long way to the downside. Yes, more liquidity and stimulus may soften the blow. However, without an underlying (and significant) improvement in economic growth leading to higher cash flows to service debt and equity liabilities as well as the likely need for higher tax revenues, markets will still remain very vulnerable.

There is arguably a double compounding as well. Not only have central banks forced investors to bid up prices to near record and in some cases ludicrous valuations, but regulators have changed the role of market making which could curtail liquidity and price discovery in a panicked market. Through various pieces of legislation, regulators have basically removed banks’ abilities to provide full market making roles in OTC markets like Foreign Exchange and bonds. What has happened is that High Frequency Traders have stepped in and changed the liquidity and market making roles.

Simply put, we doubt that liquidity will be available to sellers in the way they thought or hoped in a true panic situation. In other words, markets are not just vulnerable to much lower prices, but we could easily see air pockets as prices adjust in the absence of a truly competitive market making industry.

So, we think the risks to markets that we have discussed in recent quarters is now much more obvious. We don’t know what the end game is either in terms of political outcomes or market movements, but we think the risks of a global bear market in risk assets is now much higher. We continue to believe that a tactical and flexible approach will be required and that is exactly the way we approach markets in both good and bad times.

We obviously hope that the worst case scenarios are avoided. We hope that UK and European politicians can somehow agree on a way forward that will ensure a decent long term economic and social outcome and that markets adjust smoothly to the new and more uncertain world we live in. However, we have to be prepared for something worse in the months ahead. Not only will politicians have to think more outside the cosy box they used to live in, but central bankers will do too. The results of their policies in the post financial crisis have not taken us to a better place and more of the same is not the solution, but maybe their best answer for a short while.

The economic and financial world that existed on Thursday was full of imbalances that needed to be rebalanced. As the world adjusts, there will be greater volatility and this provides a fertile ground for macro managers like RMG. We have said for a long time that buy and hold strategies may well fall short over the next 7 to 10 years (likely before), and that style diversification should benefit investors in an uncertain world we now surely face. We will be positioning for a risk off period ahead and will provide more in depth details in the weeks ahead.

Stewart Richardson
Chief Investment Officer