BREXIT: It Wasn’t Supposed To Happen

June 24th, 2016 | posted in: Investing

by: R. Samuel Fraundorf

Yesterday, the United Kingdom voted to leave the European Union. Polls and financial markets failed to accurately predict the final vote which was in favor of exiting the EU by more than 1 million votes.  Currency markets showed the British pound hitting a new intra-year high soon after voting ended but before any counting.  As we write this, certainly things have changed from that optimistic starting point.

  • The pound is lower by as much as 11%, its largest single day fall ever;
  • European stocks are headed for their worst day since 2008, negating gains posted over the prior five days leading up to the vote;
  • US stocks are trading lower in sympathy with foreign markets, showing a decline of 3% in opening trading;
  • US Treasury yields are near the lowest levels in more than four years as capital is now seeking shelter in safety in what has become extremely volatile markets;
  • Oil is 4% lower in New York trading as worries about economic slowdown grip commodities.

An immediate impact of the vote has been the announcement by Prime Minister David Cameron of his resignation in October.

We want to summarize two key points for our clients: The positioning of their financial assets and the expected impacts of this development on the outlook from a political, economic and financial perspective. It is very early in what will be a very long cycle so our initial thoughts will need to be reviewed as markets continue to digest the news.

Portfolio Impacts of Brexit Vote

We have generally positioned our equities with a tilt toward US equities and a quality bias, and our international positions are more defensive from a sector exposure. We expect the S&P 500 to continue to be a stronger and more sought-after equity holding for global investors in light of the vote.  There is a good possibility for a recession in the U.K. and a number of economists have updated their GDP projections for the EU downward into the 0.5% range for the next year; Japan is already struggling and emerging markets may find difficult footing as well.  The quality bias in our US and international portfolios also should help in relative results as safety will tend to play well in uncertain times.

Because the surprise was so large, the initial sell-off in risk assets is also big; the MSCI EAFE index was up over 7.5% in US dollar terms over the last week heading into Thursday’s vote with France’s CAC 40 and Germany’s DAX both up similar amounts in euros. All of those gains this morning have been erased with the CAC off more than 8% and the DAX off nearly 7%.  Markets are more optimistic about British equities with the FTSE 100 off slightly less than 4%.  We have been attracted to European valuations in general, when compared to US stocks and the recent price moves make them even more attractive.

The initial reactions to financial events that are unexpected tend to be a flight to safety, including fixed income, which is exactly the reason for having that exposure in our portfolios. The concern for long-horizon investors is that more than 30% of the global sovereign bond market is paying negative interest rates (if you haven’t seen Bill Spitz’s piece on negative rates, it is well worth the read!).  We have virtually no exposure to negative yielding bonds.  Global investors will need to consider negative interest rates as they seek safety and we could see the effect of pushing more assets in to yielding equities.

Finally, we have been working to lessen the connection between our diversifier investments and global equity markets, specifically to help provide a better shock-absorber for events like this.

While we would love for all our positions to remain positive, the reality is that will not be the case in a well-diversified portfolio. However the benefits afforded from a portfolio with lower volatility means we will be better able to take advantage of the opportunities presented during times of uncertainty.

Political, Economic and Financial Fallout

Central banks have been saying the right things and are ensuring there is adequate liquidity in markets to trade and clear what will be historic volumes. We have confidence that markets will be able to handle this volatile time.

The reality of the vote is that this starts at least a two-year process of actual exit negotiations and actions, with a number of new unknowns. The resignation of the prime minister sets up a new vote in Britain which will lead to a new team interacting with Brussels.

As we stated above, we do think this vote will impact trade, consumer confidence and eventually GDP growth most directly for the U.K. and Europe. The commentary of Leave leaders that a US trade agreement will be immediately forthcoming are probably too optimistic; more than half of Britain’s trade is with continental Europe and more than a billion euro a week is traded with Ireland, all of which will be impacted by the vote.  The US should be able to minimize its economic impact to all of this, with a minor reduction in GDP expectations likely.

The fact that 32 out of 32 council areas in Scotland all voted for “Remain” is important as well. Scottish leadership has already stated that they will begin a process of negotiations with the EU and work on a new referendum on remaining in the United Kingdom.

S&P Global has stated this morning that Britain will lose its AAA rating, which seems a quick reaction to a very complex set of events. We do believe the Bank of England will need to consider easing.  In looking at how markets have initially reacted, it seems clear that everyone thinks both the U.K. and the EU will suffer, but that the EU will suffer more.  The biggest reasoning for this is the relative weakness in the EU periphery and the impact to banking and lending that will result; Italian banks seem most poised to suffer, but Greece, Portugal and Spain all have increased risks.

Finally, this vote will impact future Federal Reserve actions. Last night, as the votes were being counted, Dallas Fed President Robert Kaplan was speaking in New York and implied the Fed may now see a lower natural interest rate in the US than previously, which would mean that future rate increases by the Fed are now even less likely than before the vote.

We will continue to evaluate markets, risks and positions.  As they say in England, Keep Calm and Carry On.

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