Gambling on the EU

With quite a bit riding on the outcome of the UK vote this week, the economic players are preparing for a UK exit risk from the European Union. The Bank of England reportedly increased member bank reserves $3.5 billion in anticipation of a BREXIT liquidity rush, while mutual funds invested in UK equities recorded redemptions last week totaling $1.1 billion. Over the past 8 weeks, total UK stock portfolios have lost nearly $3 billion, while M&A activity is off 70% from this time last year. Overseas, global central banks are also taking note, including Fed Chair Yellen in her recent remarks, and in Japan, with the BoJ also noting it was making contingency plans for Brexit. Adding fuel to the fire, last week the wire houses were adding their own comments to the UK pain, with Morgan Stanley commenting that the FTSE 100 could fall 16% from current levels, and Goldman Sachs noting that sterling could decline 11% on a trade-weighted basis against a basket of currencies. We’re definitely expecting an interesting week ahead.



Energy/Commodities

Brexit poses more downside risk from “Leave” than upside risk from “Remain” for global oil markets. Concerns about a potential UK exit from the EU are weighing on investors’ risk appetite, and has boosted the USD, both of which pushed oil down much of the past week. As some polls started shifting back towards “Remain” late in the week, risk appetite improved and the USD weakened, supporting higher oil prices on Friday. If the UK votes to remain in the EU we would expect a relief rally, but some of this was likely priced in late last week. In same light, a “Leave” result could offer a deal more downside risk.

In the event Brexit is the decision, oil could be impacted on three fronts near-term:

1) The direct demand from slower GDP growth; economists at Morgan Stanley expect a potential Leave vote would lead to a downward revision in EU GDP, which would then affect oil demand. A Eurozone slowdown would likely also have consequences for the US and EM. As a rough rule of thumb, the long run global GDP multiplier for oil demand has been closer to 0.5 before considering conservation and price elasticity. Recently that multiplier has been running far lower in the developed markets (the past year or two aside for the US), and closer to 0.5 in EM.

2) Risk off and sentiment; much of the strength in the oil bid over the past few months has come from quant funds/CTAs and macro funds. These positions are more sensitive to macro events, currency fluctuations, (FX) and momentum than they are to oil fundamentals. If risk assets sell off broadly, oil will follow, typically with a higher beta - as shown this past week. Therefore, a macro-linked liquidation of these long positions is one of the greater risks for oil price stability.

3) A stronger trade-weighted USD; the inverse oil-USD link has been powerful over the past 18 months, representing almost all of the price action since the US payroll report on June 3rd. While oil’s USD sensitivity can vary, every point on the trade-weighted USD is typically worth $1.50-2.00 for oil.

Per recent sell-side commentary, the vast majority of investors are bullish on oil, but most have a “buy the dip” mentality. There is also a lot of talk about Brexit and the need for resolution there before putting more capital to work. This theme is strikingly similar to conversations we heard a couple of months ago, (i.e. bullish the commodity, worried about valuations, waiting for pullback to really get involved). Given the trend in recent commentary, it would appear that many investors have lightened up in terms of their energy weights, but are closely watching the tape and waiting to plug more capital back into sector. Hedge funds have cut exposure and are currently running market neutral, while ‘long only’ funds are increasing their weighting and adding more beta to their books. The net result is that it’s beginning to feel like there is a floor under the pricing for the sector.

Tom L. Stringfellow is president and chief investment officer of Frost Investment Advisors.

First « 1 2 » Next