Time To Rotate Out Of Stocks And Into… Overpriced Bonds?

It wasn’t a good week for stocks.

The Dow and the S&P shed more than 1% while the Nasdaq lost nearly 2%. The problem: the UK may vote to leave the EU next week. “Brexit” - like “Grexit” before it - is something that most US equity investors neither care about nor want to hear about, but nevertheless, the event risk surrounding the referendum is what’s driving markets.

As we discussed on Friday, the vote is important not only for the future of British politics and for London’s future as a global financial hub, but also for what it might entail for other disaffected EU nations which, at this juncture, is pretty much all of them. Nearly everyone has something to complain about. The periphery resents Brussels for mandating painful fiscal retrenchment (i.e. austerity). The core is angry at Brussels for pushing an open-door policy on immigration that some political parties and disaffected citizens believe is tearing at the fabric of what it means to be European. In short: everyone is mad, and a UK “leave” vote might just be the first domino to fall.

The IMF is of course doing its part to promote the “stay” vote. Here’s what the Fund said in its latest report on the UK economy:

"[While we realize it’s] a choice for U.K voters to make and that their decisions will reflect both economic and noneconomic factors, the IMF Executive Directors agreed that the net economic effects of leaving the EU would likely be negative and substantial.”  “

“In the event of a vote to leave, Directors recommended that policies be geared toward supporting stability and reducing uncertainty.”

In other words: “We realize this is your choice and all and we realize you shouldn’t only be thinking about financial markets, but this is going to be really, really bad for you.”

So how likely is it that this comes to fruition? What are the chances the UK actually votes to leave? Well, frankly, they’re about even money:

(Chart: BofAML)

“With significant negative long term implications for the UK economy following Brexit the Bank of England (BOE) is likely to cut rates and do QE,” BofAML wrote on Friday, adding that “while we are QE sceptics in terms of the ability to boost economic growth, the BOE certainly has the ability to bring down long term interest rates in the UK.”

Speaking of QE and long-term interest rates, Brexit jitters drove global bond yields to all-time lows this week with the yield on the 10-year German bund and the 30-year Swiss government bond both turning negative. So what should you do? Well, according to Deutsche Bank, you should .. drum roll… buy more bonds. Specifically, US Treasurys. Here’s a look at the correlation between yields on the 10Y and UK “stay” odds:

(Chart: Deutsche Bank)

And here’s how Deutsche Bank sums up the situation:

“Ostensibly the latest move lower has been correlated with – up till now - a mild “risk off” in terms of US equities, falling breakevens via the shift in the odds around the UK referendum. While this is an important issue we doubt regardless of the outcome that the inherent uncertainties as regards the global economic outlook will be resolved. It is tempting to consider the recent correlations and suggests that on Remain 10s might retrace to over 1.75 and on a “Leave” they might rally through 1.35. However the reality is that the uncertainties around the vote’s implications are as much symptomatic of the underlying challenges facing the global economy as anything else. A Remain doesn’t forever inhibit lower yields – and therefore would be a good buying opportunity.”

In other words: the angst surrounding the vote is amplified by the realization that eight years after the crisis we still have subdued global growth and trade. Those problems won’t be resolved with a “stay” vote and therefore, if you see yields spike on risk-on following a “remain” result, it would be time to hit the bid on US paper.

And what about stocks? Surely it’s better to buy overpriced equities than to buy into a historic (and possibly lunatic) rally in government bonds? Maybe. But maybe not. And on that note, we’ll leave you with one last chart from Deutsche which is good food for thought headed into next week.

(Chart: Deutsche)

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