What to make of “Brexit”

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SUMMARY:

The United Kingdom’s vote last week to leave the European Union has global significance, but it may take years to know the full impact. The U.K. is likely to feel long-term affects. In the short term, uncertainty about the degree of global ripple-effect makes investment markets nervous. Thoughts and general guidance are outlined below:

Given tepid global economic growth, the medium-term stock market outlook that was already guarded before Brexit is a bit more so now, however not necessarily bearish.

Such circumstances make discipline and careful planning (vs. emotional decisions) even more important for people and organizations with long-term horizons, in the context of the following:

  1. Straying from your long-term plan and strategic stock/bond mix (i.e. consistent with your planning) due to short-term concerns can harm goal achievement.
  2. While cash and bonds may have short-term appeal, cash consistently loses against inflation, potential bond rate risk is high and getting higher, and missing market recoveries is where real damage is done.
  3. Global/broad diversification is important. Despite the more recent dominance of the U.S. stock market vs. international equity markets, top performance has historically alternated between those major stock groupings, and a U.S.-centric stock portfolio leaves potentially valuable opportunities on the table and may have higher risk than a global portfolio.
  4. Market dips create rebalancing opportunities, and active investment managers within portfolios evaluate holdings for adjustments, including low-price buying opportunities when securities are over-sold.

BACKGROUND & DETAILS:

The European Union (EU) is an economic and political union of 28 countries (soon to be 27). It originated out of a movement to create unity between Germany and France following World War II, to foster economic cooperation. Countries that share commerce experience greater peace. It started with six countries and has grown over time.

The EU’s population is over 500 million, with a GDP of $18 trillion. The US has 330 million people and a similarly-sized GDP. The 28 countries within the European Union are Austria, Belgium, Bulgaria, Croatia, The Republic of Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and the United Kingdom (England, Wales, Scotland, and Northern Ireland).

EU countries are independent but agree to free trade and labor movement within the union.

Of the 28 countries in the EU, 19 of them use the Euro as their common currency. This group is referred the “Eurozone.” The UK is not part of the Eurozone and has maintained the British Pound as its currency.

What led to Brexit?

Due to growing social and political tension, a referendum was called in the United Kingdom to vote on staying or leaving in the EU. The voting occurred June 23rd, and Leave’s 52% vote surpassed Remain’s 48%. Fear of job losses and cultural identity erosion related to concerns about immigration were driving forces behind the Leave vote, partly after 330,000 immigrants entered the UK in 2015. With Turkey potentially becoming an EU country in the next few years, many Brits were concerned about the 77 million mostly Muslim Turks being able to freely enter the UK. Other concerns included the costs associated with being a part of the EU and its bureaucracy, as well as concerns about UK sovereignty.

UK graph
Source: Bloomberg, IPSOS MORI

The vote to Leave surprised investors – the global equity markets and British Pound experienced strong performance before the vote in anticipation of Remain winning. However, as it became clear that Leave was going to win the referendum, the British Pound dropped more than 10% overnight, and global equity markets dropped. The yield on the 10- year US Treasury fell to 1.5% – nearly as low as the depths of the 2008 global financial crisis – as money flowed into safer assets. Volatility in risky assets spiked, and the price of gold, a “fear asset”. got a boost.

What are the implications of Brexit?

There will be an economic impact, however it will take time to see how it unfolds. The treaties and trade agreements between the UK and the remaining EU countries are very complex. The speed and method by which the UK will remove itself from the EU is yet to be determined, and negotiations are expected to take at least a few years – the UK government prefers a slow process to minimize the economic impact, while the EU prefers expediency to send the signal that there is a price to pay for withdrawing. What is clear is that leaving the EU creates uncertainty in one of the largest economic areas of the world, and markets react nervously to uncertainty. As a result, volatility should be expected in the equity, currency and fixed income markets for the foreseeable future as the Brexit is processed.

Brexit’s most significant effect will that of economic harm to the UK. The UK’s departure weakens London’s current standing as a global financial hub, and trade with EU countries will be more difficult. As a result, the UK’s local companies and economy will see slower economic growth and possibly higher unemployment… Ironically the reverse effect of one of the Leave group’s goals.

Political ramifications and contagion are also a concern. The British Prime Minister, David Cameron, was a Remain proponent and is expected to resign. Scotland may conduct another referendum to vote on exiting the UK (a measure that failed earlier in 2016). And growing similar concerns in other EU countries may lead to more referendums to exit the EU. However, the Brexit shock to the EU may cause EU officials in Brussels to reform, which could improve country retention. But reform could also weaken the economic power of deeper unification.

In essence, emotions and nationalism overpowered economic arguments, indicating that voters are experiencing more concern than benefits from globalization. Nationalist and populist movements are also gaining traction in other developed countries in recent years, including in the US. Slow growth after the 2008 financial crisis led to levels of economic inequality not seen since the 1920’s.  Weak wage growth, rising debt, and stagnated standards of living have increased criticism of globalization as free trade, immigration and automation are increasingly seen as threats by blue collar workers whose skills have not kept pace with better opportunities.

What should investors do?

First, it is critical not to make knee-jerk, emotional decisions during periods of market volatility. Financial markets price-in expectations of the future, and often can over-react to news. Expect volatility to wax and wane in tandem with uncertainty.

The effects of Brexit over the short- and long-term are to de determined. A major country has never exited the EU (Greenland and Algeria are the only countries to exit previously and under different EU arrangements). Some economists are forecasting a bleak outlook for the UK and Europe as a result of Brexit, while others say that such predictions are overblown.

Volatility may increase before it subsides. As outlined in the summary above, staying the course is advisable for long-term investors. Changing strategies mid-stream during bumpy markets often damages outcomes.

Over the past 30 years markets have experienced many surprises and uncertainty stemming from the Savings and Loan Crisis, the fall of the Soviet Union, the first Iraq War, Asian financial crisis, Russian bond crisis, blow up of Long-Term Capital Management, the Dot-Com bubble and burst, September 11th, the war(s) against terror, the housing bubble, the Great Recession, the debt ceiling debacle, the downgrade of US Treasuries, and the European Debt Crisis.

Over these decades of ups and downs, studies show that disciplined investors fared better than emotional investors. The market is an auction and is it is the “panic group” of investors that pushes prices down temporarily, creating opportunities for the “profit group” of true long-term investors. Patience pays.

 

Please contact us with any questions or concerns.

Note: for more posts related to market fluctuations, select our “Staying the course” blog category.

 

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