Yesterday, by a narrow margin, the citizens of the United Kingdom voted to exit the European Union. This move was quite unexpected by financial markets, as pollsters had predicted the chances of a so-called “Brexit” at only 1 in 4. Markets had enjoyed a relief rally this week, moving up on the belief that the UK would vote to remain. This surprise outcome has roiled financial markets today, particularly in Europe, where investors are selling on the speculation that the UK decision will further hamper worldwide economic growth. The value of the British pound has plunged on currency exchange markets to its lowest level in 30 years, while perceived safe haven assets including US Treasuries and the Japanese Yen have rallied. David Cameron, after strongly urging his country to remain in the EU, today announced he would step down as UK’s Prime Minister, calling for “fresh leadership.”
"..it is because last night’s outcome was unexpected that the market reaction is exaggerated."
While major US stock indices have been off more than 3% today, it is encouraging that markets have been trading in an orderly fashion and have not fallen nearly as sharply as overnight futures had predicted. This is partially thanks to a chorus of central bankers who assured investors they will continue to flood markets with the necessary liquidity to ensure their orderly function. So far, utility stocks are the only S&P sector to move higher as investors seek their higher yields and relative safety. Conversely, bank stocks have fallen more sharply, down an average of 6% on belief that the Brexit will keep the US Federal Reserve dovish and interest rates in check for even longer.
What Does The Brexit Actually Mean?
First of all, it’s important to remember that while unsettling, the Brexit is not the same, as say — Lehman Brothers declaring bankruptcy in 2008. Just yesterday, the Fed announced that the major US banks passed its most recent “stress tests” and the US financial system is healthy and well positioned to weather periodic shocks to global markets. And while the decision by the UK to leave Europe certainly fuels concern about an already weak global economy, it does not signal that the financial system itself is at risk.
What remains to be seen is how the British will negotiate their “divorce” from the EU. It will be complicated, and will not happen overnight. In fact, in our view, it will likely transpire in multiple phases over the course of several years. The International Monetary Fund’s Christine Lagarde indicated prior to the Brexit vote that such a move would likely push Britain into a recession in 2017, as businesses disinvest and move jobs from London to other EU members, and the pound loses value relative to global currencies. Therefore, it’s in both the EU and the UK’s best interests to create a calm and orderly plan, and we believe both sides will grudgingly negotiate a series of compromises that minimize long term damage to the European economy. Neither the EU or the UK should be interested in moving with haste, and we do not believe the Brexit changes the US economic outlook longer term.
"...it’s in both the EU and the UK’s best interests to create a calm and orderly plan. "
Remember: This Is No Time To Panic!
The reason today’s market reaction is so negative is because the outcome of the British vote was largely a surprise. Markets do not like surprises, and nervous investors tend to sell first and ask questions later. In reality, no one knows exactly what the Brexit decision means for Europe and the global economy long term, and it is because last night’s outcome was unexpected that the market reaction is exaggerated.
But as we have seen time and again, as cooler heads eventually prevail, markets tend to stabilize and fundamentals resume control. In our opinion, nothing about the current economic climate or the Brexit suggests a change to a broadly diversified portfolio. Fundamentally, the Brexit won't likely hurt most US companies, although it will impact the US financial sector since it suggests the next Fed rate hike will be further delayed. It does create further ambiguity for markets — which is rarely helpful — in the short-term.
Market watchers are rightly concerned about the potential for a global and US recession after a weak May jobs report, subdued business investment, and weakening consumer sentiment. The Brexit vote simply adds fuel to those existing fears, as sharp moves in currency markets serve to tighten financial conditions. Central bankers, including the Bank of England, are promising to flood markets with cash as needed, and in our view, this is critical to restore investor calm. As result, analysts now expect that the US Fed will delay any future rate hikes until possibly as late as 2017.
But, remember, no one can predict the future. Periods of market anxiety, economic recessions, and the occasional bear market are all a normal part of successful investing. When other investors panic, it is imperative to remain calm and take an even approach. By gradually adjusting portfolio allocations through disciplined rebalancing, investors can avoid the emotional decision making that undermines long term growth, and seek to profit from short-term volatility.