July 2016 Newsletter
Brexit & Beyond
In This Month’s Issue
We examine the domestic economic implications of the United Kingdom’s unexpected decision to leave the European Union.
Occasionally, the financial markets will make a bet that is not particularly grounded in fundamental reality. This phenomenon was on display during the week of June 20th with the British referendum on European Union membership looming that Friday. The outcome of this referendum was to be a binary event; the vote would either conclude with ‘leave’ or ‘stay’, and as such, would allow traders and investors to position themselves ahead of the vote with these two outcomes in mind. Most of the polling in the days leading up to the vote had ‘remain’ with a slight edge, but within the margin of error.
Essentially, the polls were saying all along that this was a coin flip, and the proper market response to that would have been uncertainty, with traders on either side of it. However, in the days leading up to the vote itself, the financial markets were pricing in a near certainty of ‘Bremain’. Up over 2% on the week, the S&P came close to all time highs again, but it was apparent that investors had not taken into account the possibility that Britain would actually vote to leave. And then they did. Whenever the majority of market participants are proved to have positioned themselves on the wrong side of a binary event, it is not unexpected that fear and volatility follow as the predictive power of the market collective is shown (once again) to be weak.
Funny, isn’t it. You know, when I came here 17 years ago, and I said that I wanted to lead a campaign to get Britain to leave the European Union, you all laughed at me. Well I have to say, you’re not laughing now are you?
Nigel Farage, head of UK Independence Party
The Only Certainty Now is Uncertainty
When we woke up on Monday morning, the UK was still a member of the EU. They will still be a member next week, next month and most likely for the next year or more. The process of unwinding their membership is not explicitly spelled out and will require extensive negotiations, almost certainly with a new government at the helm in the UK. Markets generally do not like uncertainty and this vote introduced quite a few layers of it. Who will the new leaders be? How quickly will the sides push for the process to get underway and completed? Is there any constitutional recourse that Scotland and Northern Ireland can undertake to potentially block the exit altogether? Will they hold new referendums on their own independence? Ultimately, how will these uncertainties manifest themselves on the global financial markets and economies?
The spectrum of possibility over the weeks and months to come spans a rather wide set of outcomes. On the side of risk, there is that of political contagion. A Brexit could further embolden protectionist coalitions in other countries vying for their own chance at a membership referendum, and we just saw what could happen when such a major decision is left up to the whims of the masses. It may not be likely, but it is certainly possible that we look back on this event as the first domino in the fall of the EU. On the other hand there is another small, but also possible, outcome in which Brexit never actually occurs. Since David Cameron has decided to resign without triggering the formal process under what is known as the Article 50 provision, he is leaving it up to his successor to make that call.
It is important to note that the referendum is not binding, and parliament is not required to go along in the same direction. It may come to pass that the practical realities of the process prove too destructive to bear, and those who led the charge may be forced to balk at the implementation of it.
What Does Brexit Mean for the US?
While that notion is interesting to ponder, we have to assume at this point that exit will become a reality. With that in mind, it is likely that investing in the UK will be on a freeze for the time being. It would be difficult to justify capital commitments on a 10+ year time horizon when the immediate future has so many moving parts. However, sometimes for better and sometimes for worse, the vast majority of the US economy is driven by internal consumption and investment.
According to LPL Research, despite exports more than doubling as a share of our gross domestic product (GDP) over the last 40 years (figure 2), exports still account for less than 15% of GDP. The US exports approximately $125 billion of goods and services to the UK, accounting for less than 5% of total exports, and $375 billion to the rest of the EU, accounting for about 17% of exports. Put all of that together and less than 4% of our GDP comes from trade with the Eurozone. As a result of the anticipated slowdown, Goldman Sachs cut their outlook for US GDP in the second half of the year by .25% to 2%. Any cut to expectations hurts in a low growth environment, but that is hardly catastrophic or recession inducing in and of itself.
Reinforcing the idea of at least modest insulation from the rest of the world, both European and emerging market indices have been in bear territory for much of the last 2 years, as the US markets have to this point been fairly resilient (Chart of the month).
While this vote has just shown us that there are no sure things, the rate hike expectations for the Federal Reserve are entirely off the table until at least the fourth quarter, and currently the market is actually assigning better odds for a rate cut out until February 2017. This is a rather remarkable about face from where we were just a few short weeks ago. This environment should theoretically be positive for US equities, especially those small and middle market companies that generate the majority of their revenues domestically. Companies with outsized European exposure, like some multinational S&P components and the big banking players will likely bear the brunt of any headwinds from a European slowdown.
The bottom line is that it is difficult to predict with any degree of certainty in what direction this saga will unfold, but we will continue to diversify out risk exposures and remain focused on long term objectives.
Chart of the Month
In this five year chart, we can see the relative performance between the S&P 500 (Blue, top), the MSCI EAFE (Red, middle) and the MSCI Emerging Markets (Green, bottom). Despite the Greek crisis, Chinese economic slowdown and other international troubles over that time period, our domestic markets have largely been resilient to these challenges.
Important Disclosure Notices
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine what is appropriate for you, consult a qualified professional.
Investing involves risk, including possible loss of principal.
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Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
The S&P 500 is an unmanaged index. An index cannot be invested in directly.
Investments in foreign securities involve certain risks that differ from the risks of investing in domestic securities. Adverse political, economic, social or other conditions in a foreign country may make the stocks of that country difficult or impossible to sell. It is more difficult to obtain reliable information about some foreign securities. The costs of investing in some foreign markets may be higher than investing in domestic markets. Investments in foreign securities also are subject to currency fluctuations.
Tactical allocation may involve more frequent buying and selling of assets and will tend to generate higher transaction cost. Investors should consider the tax consequences of moving positions more frequently.
The prices of small cap stocks are generally more volatile than large cap stocks.
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