Sectors

We test three channels of contagion from the Brexit shock: political, banking system, and economic.

There is a strong incentive for homeowners to invest in their own homes, as existing home prices have eclipsed pre-crisis peaks. Mortgage credit is also readily available and growing again after a multiyear contraction, which will aid in the resale process. There is significant scope for mortgage credit to grow, which implies a long sales runway for home improvement retailers. The latter had battened down the hatches following the housing crisis, closing stores and curtailing investment. Low construction spending is supportive of near-term same-store sales performance, and also implies that the industry can shift back into expansion mode at some point. If so, then historically appealing relative valuation levels have room to expand. We recommend moving back to an overweight stance in this group. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5HOMI- HD, LOW.

The decline in global bond yields and negative interest rates outside the U.S. represent a windfall for U.S. housing, to the extent that U.S. mortgage rates are pushed below levels warranted on U.S. fundamentals alone. With a fully functioning banking system, and a willingness to extend mortgage credit, the housing sector should accelerate in the second half of the year. By extension, the S&P home improvement retailing index is poised for liftoff. The group has corrected laterally in recent months, ignoring the bullish signal from the plunge in Treasury yields (shown inverted, top panel). There is already evidence that lower mortgage rates are stoking housing demand: mortgage purchase applications are gaining traction after a long slumber, and refinancing activity is perking up. Mortgage rates have declined sufficiently to make refinancing a viable option for many homeowners. As housing-related financing becomes more readily accessible, the means and incentive to undertake renovation projects should accelerate. The NAHB remodeling survey has been grinding lower, but a reversal is likely given rising mortgage demand and a high level of pending home sales, a catalyst for home improvement projects. Importantly, there is a long runway for growth ahead, please the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI- HD, LOW.

A number of divergences have emerged in global financial markets. These gaps are unsustainable. The recent improvement in Asian trade/manufacturing has been largely due to firming demand for electronics/semiconductors. Meanwhile, demand/output for industrial goods and basic materials - the areas leveraged to Chinese capital spending - remain weak. Fixed-income traders should bet on yield curve steepening in India: receive 1-year/pay 10-year swap rates.

Housing activity should accelerate in the back half of the year given the drop in Treasury yields. Buy home improvement retailers and add to long homebuilding positions.

Some near-term upside in Treasury yields is very likely as flight to safety flows begin to unwind. However, given that global growth divergences remain in place, we will continue to look for an opportunity to increase duration on any meaningful back-up in yields.

Financial stocks around the world have plunged, with U.S. relative performance on the cusp of setting new cyclical relative performance lows. While the sector is well capitalized and has low balance sheet risk, our negative stance is predicated on income statement concerns. Brexit represents another deflationary shock in a world struggling to generate trend growth. To the extent that faltering economic confidence further undermines business activity and sends capital to the perceived safety of the U.S. dollar, it amounts to a tightening in global financial conditions. Under these conditions, downward pressure on the interest rate structure will persist (second panel), robbing the financial sector of a much needed source of income. Thus, while the financial sector appears 'cheap', it is still too soon to consider bottom fishing, at least until deflationary pressures subside. We reiterate our below-benchmark position. The ticker symbols for the stocks in this index are: BLBG: S5FINL.

While the economic fallout from Brexit is likely to play out over a long horizon as the U.K.'s exit is negotiated, this political event will have repercussions for U.S. equity markets in the interim. For instance, defensive sectors have surged, in relative performance terms. Since the financial crisis, consumers' propensity to save has steadily climbed. That has coincided with increased traffic at non-cyclical retail stores, to the extent that their sales have largely outpaced overall retail sales in recent years, which is unusual during an economic expansion. Policy and political uncertainty are likely to fuel this trend. Thus, the consumer staples sector should continue to enjoy an upward re-rating in relative forward earnings estimates. Both valuations and technical conditions are below previous overbought extremes, underscoring that there are few barriers to ongoing stealth outperformance. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5CONS.

Post-Brexit uncertainty will continue for some time. But we were already cautiously positioned, and would not go any more defensive.

The Brexit drama has moved from the realms of psephology into the realms of game theory. How will the game play out? And how will the economy and financial markets react?