How To Build A Post-Referendum, Absolute Return Portfolio

How To Build A Post-Referendum, Absolute Return Portfolio

How To Build A Post-Referendum, Absolute Return Portfolio

The existing environment presents a challenging array of sporadic correlations between assets, with financial and economic theory often substituted with subjective psychological impulses. Several factors such as central bank interventions (specifically US, European and Japanese central banks), volatile commodity prices and, more recently, the Referendum outcome, continue to take the front stage as drivers of global markets. With government bonds drifting into negative territories and markets awash with central bank-conceived capital, the search for yield has resulted in unjustified valuations for equities and volatile flows of funds.

In response to the current climate, the alpha-seeking portfolio below analyses a selection of views across various asset classes.

Long viewed as an inflation hedge, gold prices like other commodities have historically demonstrated a correlation with inflation rates. However, human psychology has transformed the commodity into a perceived safe haven enabling it to prosper through volatile markets, as shown by recent Brexit events. The Referendum resulted in investors fleeing from the pound to haven currencies such as the yen (to the dismay of the Bank of Japan), Swiss franc and dollar. Meanwhile dollar-denominated Gold displayed its safe haven status despite the dollar strengthening considerably.

Gold price movements since 2012 (Source: Bloomberg)

With the destabilisation of Europe increasing in likelihood and the pound on a downward trend, holding bullion, gold exchange traded funds (ETFs) or gold miners such as Randgold Resources (or other relatively low-geared miners) can act as a profitable hedge against more adventurous positions. As a long play, upside potential is available on account of the Federal Reserve resisting hiking up rates (the next rate hike will probably take place in 2017 due to potential headwinds to growth such as US Elections and poor recent non-farm payrolls data) with momentum able to break $1.400/ounce.

Like gold, oil has no intrinsic value. Unlike gold, however, oil is driven by a combination of supply and demand. The strengthening of the dollar that followed the referendum, alongside the overarching risk off sentiment, resulted in oil prices trickling to $48. Oil has since recovered but with currency markets still searching for new equilibriums, dollar movements are likely to burden the commodity further. Additional pressure will arise as anti-EU political parties gain strength in response to the Referendum result which risks the disassembly of the custom union, creating an imminent recessionary outlook.

Market movements of Oil and companies in the Oil industry since 2014. Blue = Brent Crude, Green = Marathon Oil (Pure downstream), Orange = Transocean (Pure upstream), Red = Exxon Mobile (Integrated).

The recent recovery in oil prices from lows of $28 to todays $50 has been driven by a combination of supply disruptions such as the Canadian wildfires, reduction in investment in oil production assets (affecting long-term supply), and an increase in worldwide, consumer-driven demand. However, as the outages fade, the supply glut will return to focus on Iran (through the removal of sanctions), Russia (through the rubles depreciation) and other oil-producing countries increasing output and US shale demanding attention. One should remain bearish on this commodity (and related upstream sector firms) in the short term, and suspect the possibility of a return to $37, notwithstanding the continuous supply interruptions propping up the oil price. However, in the medium term, a rebalancing of market factors pushing the commodity to an equilibrium of $60 is expected.

Record-low yields on bonds have pushed yield-hungry investors into equities and created balloons in both markets. The Referendum produced apin-prickthrough the collapse of the pound but provided a boost to international revenues for FTSE 100 firms and a negative realisation for domestically-inclined firms. Political disorder in the Conservative and Labour parties has only created further aggravation.

Market movements after the referendum result. Blue = FTSE 250, Red = FTSE 100, Orange = Foxtons, Green = Unilever, Purple = Berkeley Group.

In the UK, the medium term points to a gloomy picture for growth and unemployment. Property developers and estate agents have collapsed in expectation of a decline in property prices, which will impact consumer spending and confidence. Reduced footfall and quarterly sales figures will show clear evidence of this. The Bank of England governor has provided an answer a pledge to avoid a credit freeze by reducing capital requirements and persuading banks to lend more. This may avert a recession but will not ease uncertainty, leaving businesses hesitant and recovery slow. In this environment, holding consumer-staples as assets will minimise the downside but taking advantage of the diversification of international companies will generate alpha.

The banking sector faced the brunt of the referendum result. With the Bank of England likely to cut rates (probably later this year rather than wasting ammunition in July) and the Federal Reserve likely to delay hiking rates, profit margins will be increasingly squeezed. Further, the referendum has created uncertainty in EU passport rights, postponed IPOs and will force banks to restructure incurring costs as they do so.

Bright spots (in relative terms) can, however, be found lurking in the shadows. US banks have performed well in recent stress tests in comparison to their European counterparts (such as Deutsche Bank) and grown organically in their core divisions. This will allow them to exploit opportunities within Europe such as through project and acquisition financing, and M&A. Activity is likely to slow down, especially as European banks will be reluctant to invest (which reduces capital ratios) with a potential crisis loitering. Holding US banks will provide a less volatile exposure to the financial sector and produce steady, if not increasing, dividends. Otherwise, domestically focussed emerging market banks, specifically Asian and African ones, offer attractive yields while being relatively sheltered from international affairs.

Italian banks are rightfully at their cheapest level in history with balance sheets clustered with non-performing loans. A collapse or nationalisation is unlikely (with the President of the European Central Bank likely to force a bail-in first and the Italian government with few available funds), but a reduction in lending credit will reduce investment and damage confidence. This negative multiplier will knock GDP into a potential recession which may spread across the region. This provides a selling opportunity against all cyclical, consumer-discretionary firms operating in the country, as they will be hit the hardest.

Uncertainty causes short-term disruptions for investors but having long-term views that tend towards risk-adjusted intrinsic values will statistically produce returns over the horizon. Diversification across sectors, regions and asset classes also combat risk. To complement this, by utilising the universe of assets and creating logical, well thought-out strategies, risks can be diversified away, and returns can be obtained in any directional market.

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