South River Asset Management view following the UK vote to leave the EU

Following the UK vote yesterday to leave the EU, we thought it would be useful to summarise current South River Asset Management investment strategy.

We had already been defensive in our asset allocation in the run-up to the EU vote arguing that equities were fairly valued and we had also hedged our sterling where we could, holding high levels of cash in US$

In the short term we continue to run a tactically cautious investment strategy with higher than benchmark levels of cash, short term bonds, an overweighting to gold and silver, energy and overweight positions in blue chip corporate bonds.  Where we are invested in single equities we are mainly invested in large cap names like BP, BHP, HSBC and ROLLS where we can pick up reasonable dividend yields of 2% to 7%.

For some time we had thought that Brexit risks had been underpriced and we had hedged our sterling positions versus US dollars where appropriate.

The reason we have been so cautious is that we believed investors were underestimating the impact of the UK’s referendum on the European polity whatever the result had been.  The fact that even with the UK government’s ability to set the agenda for the referendum, international organisations like the IMF, World Bank and OECD as well as bodies like the Bank of England all pressing the authorities’ case for staying in, Britons voted to leave the Union, and this does not bode well for further European integration in our view.   French and German general elections take place in 2017 with the French election in particular likely to be divisive. 61% of French people polled recently said they have a low opinion of the EU. Presidential front runners Emmanuel Macron for the left and Marine le Pen for the right were already talking hawkishly about repatriating some powers from Brussels and the European Commission will most likely come under considerable pressure to deliver far more wide ranging supply side reform to improve European competitiveness than it has managed to date.

Either way, we believe the path to further EU integration has become fundamentally challenged.

Likely investment consequences:

Both bears and bulls cite valuation on their side. Bulls can point to an earnings yield of 7% and dividend yield of 4% versus bonds, which even at the ten year level, are yielding a tiny 5 basis points in the case of Germany. (It is interesting to note that there is no UK gilt now yielding more than 2% while the entire Swiss yield curve is negative). Bears can point to lacklustre growth, poor pricing power and poor market technicals (pension fund cash flow eaten up by allocation to bonds) and can also point to overvaluation of the US market with CAPE (cyclically adjusted p/e ratio) at 20x, which is high historically.

Whatever the outcome of what may be difficult exit negotiations, UK and European economies will be forced in our view to engage in significant supply side economic reforms with investments in such new technologies as alternative energy (ev’s), biotechnology, aerospace as well as major investments in the electricity grid and other infrastructure.

Among sectors we favour are industrials, energy and materials while we are underweight consumer stocks and banks.

The $15bn giga factory planned to be built by VW in Germany and the announcement of subsidies for electric vehicles by London mayor Sadiq Khan, the new class of Vanguard submarines likely to be built in the UK and the $40bn order won by the French navy in Australia, and major new advances in industries as diverse as biotechnology as well as new techniques in building technology, and mining and oil extraction are all major examples of the effect such investments will have, driven as they are by innovation and research and development. Such investments will be crucial in driving economic growth across Europe in coming years.

It is to these segments we shall focus our research efforts and where we are looking to find the most interesting opportunities.

We continue to favour a diversified portfolio approach at South River Asset Management with exposure to roughly a quarter equity income, a quarter corporate bonds, a quarter cash and short term bonds and a quarter commodities and hard assets like property and infrastructure.