UK Votes to Leave the European Union
What has Happened
The U.K. has voted to leave the European Union. Polls taken prior to the vote were indicating that the UK would remain in the EU. Financial markets have responded harshly to Britain’s surprise vote, significantly impacting currency and equity markets around the globe. STOXX, the broad European equity index is down 6.7% and markets in England and Spain are down over 12% each. U.S. and Asian markets are generally down 2-3% on the news. British Prime Minister David Cameron, who was a primary proponent for the U.K. to remain in the EU, announced that he would be stepping down. The vote which appears to be a call to reclaim national sovereignty, adds uncertainty to an already fragile European economy. The vote also raises the potential for other member nations to consider their status in the EU. However, the International Monetary Fund (IMF) earlier predicted that leaving the EU would cause a severe economic impact to the U.K. which may give other countries pause before they take a similar path.
Dr. Scott Brown, Ph.D., Chief Economist for Raymond James stated that “The financial markets had mostly priced in a victory for “remain” – hence, the result is a major shock. The key economic concern is uncertainty. Ahead of the vote, there were already signs that business investment was being restrained, residential and commercial real estate transactions were be delayed, and consumers were postponing big-ticket purchases. Prime Minister David Cameron has resigned, effective October, at which time negotiations will begin with the EU on the exit – a process that is expected to take two years (as specified in Article 50 of the Lisbon Treaty). First Minister of Scotland Nicola Sturgeon said that a second referendum on Scottish independence is now “highly likely.” Other countries (France, the Netherlands, and Sweden) may push to exit the EU as well. The U.K. economy will face a long period of uncertainty, which is a negative for business investment. “
What is the Impact on U.S. Investors?
Investors very often overreact in selloffs. Campbell Harvey, a finance professor at Duke University and expert on the European Union and the Euro commented that "The markets are overreacting. The long process required before the U.K. can leave the EU will mean countries have time to renegotiate trade treaties, he added. "The rest of the world needs to embrace the U.K. mantra, ‘Keep calm, carry on,’ ” PIMCO Chief Investment Officer, Dan Ivascyn, says the firm doesn’t expect material credit risks.
Any economic damage in the U.K. will not likely have much impact on the U.S. economy. The dollar has strengthened against the Euro and the British Pound making U.S. exports more expensive in the geographic region. However, the U.K accounts for less than 4% of U.S. exports and less that 3% of U.S. imports. The Brexit vote will make it more unlikely that the U.S. Fed will increase rates during the remainder of 2016. Volatility in global markets will likely remain elevated for a time.
What should Investors do?
Investors should appreciate the importance of asset allocation and diversification particularly during times of market turbulence. The Yellowstone Partners Asset Allocation Strategies have helped to buffer the negative impact of the Brexit event. High-quality bond/fixed income investments have generally moved higher and real estate investments (REITS) are holding their own as equities and some commodities have moved lower.
High-quality investments such as investment grade bonds and dividend paying equities will likely remain in demand. Domestic corporate fundamentals have not changed. Recent earnings growth has not been strong, but it is positive and looks to improve going forward.
Some investors may be tempted to buy into the European weakness but it may be prudent to let the dust settle for a while.
Initially, we don’t expect the UK referendum to have much of an effect on the outlook for the US economy. The UK accounts for only 4% of US exports, equivalent to about 0.5% of US GDP. Even a 5% hit to the UK economy would reduce US GDP by only 0.03%. In contrast, the UK has a tougher situation with the uncertainty of how a withdrawal from the EU plays out. Adding to the uncertainty is that the exit is likely to not conclude until late 2018, due to EU law and a lengthy process of micro-negotiations. This uncertainty and time frame will affect UK investment flows, the housing market and the general economy. Any increased probability of other EU members leaving would add to the uncertainty. We view it as likely that other countries wait and see how it plays out for the UK.
Ultimately, as Greg Valliere, a Strategist with Horizon Investments, said in Barron’s, “the Brexit vote was about immigration and Islamization of Europe.” This means that the referendum was really about sovereignty and the right to control a nation’s destiny, rather than about direct economic matters such as taxes and tariffs. This probably helps Donald Trump in a small way, although he continues to poorly capitalize on issues that should be in his favor.
In investments and the economy everything happens at the margin, meaning small changes can have significant ramifications. We view most of the uncertainty as focused on Europe and its role in the global economy. But we are in uncharted territory to some extent. Spillover could be seen in the US, particularly if the US dollar stays stronger and other countries join in the exit.
On a short-term basis expect volatility, but longer term we try to be bottoms up investors in individual stocks within an asset allocation strategy that focuses on diversification and reasonable attention to appropriate risks. In earlier comments, we stated that we believed there was a reasonable chance for the S&P 500 to reach a marginal new high around 2140-2150. The highest we attained in 2016 thus far was around 2120 – near highs of the past several years. With the level as of writing now around 2050 we think it unlikely to see 2150 without some significant follow-through on the economy. Prior to May’s weaker-than-expected jobs report we were seeing some firmness in labor trends, particularly in the US building materials and housing industries. If the May job weakness was an aberration in the numbers, which we think is a reasonable conclusion, the job numbers should rebound. Along with an employment rebound we think it likely that S&P earnings rebound from the first quarter’s $105 post.
Prior to today’s developments, 10-year treasury interest rates had rebounded from a low of 1.51% to 1.70% yesterday. Early this morning they traded under 1.53% and are now around 1.58%. We would like to have rates move higher so that savers and retirees have more return on their investments. The changes we experienced this weekend may delay the rise for this year, but we believe that 2017 and 2018 are setting up to experience moderately higher rates though perhaps not beyond the recent years’ trading range of about 1.6% to 2.7%.