Policy

Long-time subscriber Mr. X recently visited our office to discuss three issues: Brexit, the outlook for China and the seeming contraction between the performance of equity and bond markets. This <i>Special Report</i> is a transcript of our conversation and, not surprisingly, the broad conclusions supported a cautious investment strategy.

A spike in economic uncertainty explains the recent move lower in Treasury yields. Given the resilience of global growth, we expect yields to rise as uncertainty ebbs in the coming months.

The blowout June nonfarm payrolls report reflects a tightening labor market, consistent with stronger ISM manufacturing and non-manufacturing readings. This will take time to impact Fed policy.

Brexit is putting our bearish short-term dollar view in question as global policy uncertainty has surged. Yet, investors are displaying elevated signs of risk aversion but the global economy still looks fine. This dissonance is likely to end with investors increasing risk taking, a bearish development for the counter-cyclical dollar. Favor commodity currencies over European ones.

There is no evidence of a sharp increase in China's state sector investment in recent months. This, together with the cautious private enterprises, explains why overall Chinese investment has remained downbeat. Public sector investment spending will likely accelerate going forward, which should continue to support business activity.

Yield and Protector Portfolios should continue to benefit in current environment. Equities face seasonal headwinds.

A benchmark overall duration stance is still warranted, as central banks will maintain exceptionally accommodative monetary policies to offset potential Brexit-related shocks to confidence.

Global uncertainty is elevated, but markets know this. Brexit could prove extremely negative for the global economy if it prompts a questioning of the EU's integrity. The cyclical outlook for the pound remains poor, but a short-term opportunity to buy GBP/JPY has emerged. We still like the SEK and commodity currencies. The SNB will continue to intervene, but the peg is increasingly dangerous.

Even if commodity markets are not yet pricing a higher probability of fiscal stimulus following the U.K.'s Brexit vote, we believe they will begin doing so in very short order.

The Brexit vote has ended the reflation trade, but does not represent a "Lehman moment" either. Stick close to benchmark in terms of broad asset allocation, and watch European bank CDS for signs that another financial crisis is brewing.