Covenant Weekly Market Synopsis as of June 24, 2016

June 26, 2016

The UK’s referendum to exit the European Union (aka “Brexit”) shocked the world – full stop. As it became clear that the referendum would pass late Thursday evening, financial markets began to convulse, primarily because most investors were positioned for it to fail (more on this below in the “Ocean’s 11” section). Taking a step back however, while Friday’s equity market losses were large, in most cases they simply gave back some or all of the gains that had accrued over the previous five trading days.


Source: Bloomberg and Covenant Investment Research

That’s not to say that equity markets have reached a long-term equilibrium – they likely have not. I just thought I would put Friday’s equity market movements into context. Financial markets dislike uncertainty and the UK referendum results have injected a huge amount of uncertainty into the markets that will have far reaching reverberations on politics, central bank policies and, of course, financial assets as this whole process plays out over a multiple year time horizon.

While the equity market swings were large, currency markets were even more volatile as the British pound declined 11.9% upon news of the referendum, and ended the day slightly better off by 9%. Yields on fixed income investments were squeezed tighter as investors sought cover from the storm: 10-year UST 1.56% (from 1.77% the day before), German 10-year Bund -0.05% (+0.09%), Japanese JGBs -0.19% (-0.16%).

Please click here to view detailed asset class performance.

Brexit – maybe, maybe not: What is interesting about last week’s vote is that the referendum does not have any legal consequences and that withdrawal from the EU will require an act of British parliament. According to BCA Research, it is entirely possible that the UK will hold a second referendum once the UK completes negotiations with the EU (likely more than 2 years away). So while most of the media outlets were acting as if the Brexit was effective last week that simply isn’t the case.

Ocean’s 11 Brexit style: Stick with me on this one as it is a tad long, but understanding this rumored financial-market “con-job” requires context.

Background. In the run-up to Brexit two types of data sources were regularly used to predict the outcome of the referendum: traditional polls (telephone and in-person) and online gambling sites. The former implied that the vote would be too close to call, while the latter (where real money changed hands) indicated a high probability Britain would remain in the EU. During the 2014 Scottish referendum to separate from the UK (ironically) gamblers correctly predicted Scotland would remain in the UK, even though the polls strongly suggested otherwise. Drawing a parallel to the Scottish referendum, media pundits (and apparently a lot of investors) were confident that Bremain would triumph over Brexit.

The Set-Up. (a website for people who wager on political events) estimated that about $30 million was being wagered on the outcome of the referendum. Of that $30 million, 75% of the total money bet had been placed on Bremain, however 75% of the individual bets were placed on Brexit. In other words, 3 out of every 4 bets (though small in size) were on Brexit, with only 1 of 4 bets on Bremain. Collectively the size of the bets on Bremain were much larger than the bets on Brexit. As a result, less than 24 hours before the actual voting began the gambling odds were overwhelmingly pointing towards the UK remaining with the EU.

The Payoff. A hedge fund manager friend related to me early on Friday morning (after the votes had been counted and Brexit was confirmed) that a rumor was circulating through the industry that a firm or a person used the online gambling sites to spoof the market and media into believing that Bremain was nearly a sure thing. At the same time this individual or firm positioned their portfolio to profit from a Brexit. If true, it was a brilliant play: bet $15mm – $20mm to skew the gambling odds towards a Bremain outcome to make 10x that amount or more in the financial markets on Brexit. This is the type of arbitrage that a great risk taker like George Soros might structure – that is not an indictment of Mr. Soros, merely a nod to someone who has made a lot of money from shorting the British Pound in the past.

Words?:  Brexit, Grexit, Frexit (France leaving the EU), the word mashups keep coming. When did bastardizing the English language become a cool thing to do? My bride says the first entry into the English lexicon was when power celebrity couple Ben Affleck and Jennifer Lopez became “Bennifer” (source: Michelle Pawl). No doubt a Texas secession from the U.S. would be called a Texit, but if Donald Trump fails to win the Presidential election will it be called a “Trumpit”? (sorry, that’s pretty bad).

Economic Data Wrap-Up: Existing Home Sales for May rose in line with consensus estimates to a 9-year high 5.5mm annual rate. The market for existing homes remains tight at 4.7 months, the sixth consecutive month under 5. Reflecting that tightness, the median home price rose 4.7% year-over-year. New Home Sales declined following a large print in April, but remain in a solid upward trend. Moreover, leading indicators such as number of homes for sale and an increase in months’ supply, augur for continued sales growth through the summer. Durable Goods Orders fell more than expected in May, as a strong US dollar and weak global demand continue to pressure the manufacturing sector. 

Be well and Godspeed,