By Thomas J. Connelly, CFA, CFP
This article was first published on our website on June 29, 2016. Since Britain’s decision to leave the European Union there have been questions about its effect on the economy, democracy and security, and complaints of muddied information by British campaigners and the media. In this article, Tom Connelly, Versant President and Chief Investment Officer, breaks down the Brexit vote and what the future investment landscape may look like.
On Thursday, June 23rd, citizens of the United Kingdom voted to terminate their status as members of the European Union (EU) in a non-binding referendum. The vote split was approximately 52 percent in favor of leaving and 48 percent for staying on a 70 percent turnout. The next step lies in the political rather than the legal realm. The Conservative Party needs to sort out who will succeed Prime Minister David Cameron, who stepped down Friday morning. If the Conservatives cannot rapidly anoint a successor without dividing the party, a general election might be the result. In any case, the leadership issue should be sorted out by sometime in September, just before the October Party Conference on October 2-5. In the meantime, we all have the EU leader’s summit on June 28-29 to look forward to for some clarity on the continent’s thoughts. The UK would aim to leave the EU by the end of 2019.
Proponents of “Leave” want the EU to offer access to the single EU market for trade purposes, but no EU oversight, contributions, or acceptance of free movement of labor. This is essentially having your cake and eating it too; and if the EU acquiesced to these changes, it would have every member outside of Germany knocking on its door for a new deal. It is difficult to imagine that the EU will be terribly lenient in negotiations in light of the recent past. After a totally ineffectual Greek referendum protesting EU enforced austerity, the EU forced the Greeks to acquiesce on almost every major negotiating point, against a backdrop of grueling negotiations, that helped generate global financial chaos across the globe and a Greek economy frozen in depression last year. They could not afford to be lenient with Greece, because Ireland, Portugal, Spain, Italy, and probably France would have been next in line to pick the German’s pockets.
The “Leave” vote is less about finances or austerity than issues revolving around sovereignty, and most of all, I believe, immigration. Reduction of the record number of foreign nationals streaming into the country has been a spark for the rebellion. Some of the Conservative Party’s government policy objectives are in direct contravention of EU law.
EU-imposed immigration policies, especially in light of recent violence in France and Belgium, are placing huge stresses on the European Union. On the continent, the southern periphery is in need of economic stimulation, while the developed core around Germany is growing very well, and does not need stimulus. A common currency, but not combined political or fiscal authority in Europe, makes the problem difficult to solve. The European project was ultimately meant to unify Europe, economically and politically, with the currency union as a critical first step. The EU must survive this latest challenge for the long-term vision to come to fruition.
What are the Next Steps?
The first thing to remember is that the vote on June 23rd was not legally binding; it was a referendum. The next step lies in the political rather than the legal realm, and Parliament will probably invoke Article 50 of the Lisbon Treaty on the recommendation of new party leadership. Article 50 covers the legal obligations of EU members; it is not clear to what extent Article 50 covers the trading relationship between the UK and the EU. There is no protocol in the Lisbon Treaty to reverse an Article 50 submission. After invocation of Article 50 by the UK, the European Commission recommends a course of action to the Council of Ministers of the remaining 27 members, which must approve the proposed agreement via a super-majority vote. The UK and European Parliaments must also approve the agreement.
The consensus seems to be that the withdrawal agreement will happen over two years, while the relationship between the UK and the rest of the EU will be negotiated over five years, and the UK’s relationship with the rest of the world will take a decade or more.
A Wake-Up Call
We do not subscribe to the position that the Brexit vote is a death knell to global trade policy, although politicians in Europe and the US are using anti-globalization sentiment as a rallying cry. Perhaps what is happening in the UK, and subsequent market movements and global concerns over the vote, are a wakeup call, demonstrating just how economically interconnected the world is.
The Brexit outcome might be tough for the UK economically and financially, but is unlikely to tip the world into instability. The UK didn’t join the European currency union, and can still adjust its currency value and also run deficits. The big risk is the potential for a sharp reversal of capital flows, which would be particularly dangerous given the 7 percent current account deficit posted at the end of 2015. The UK exports 12 percent of its GDP to the rest of the EU, but imports only 3 percent of GDP from the EU. All of the world’s major central banks have said they are willing to provide exceptional liquidity if necessary, including access to credit in other currencies. A reprise of a systemic event like the Global Financial Crisis is thus unlikely. Economists have estimated a post-Brexit decline in the GDP of the UK ranging from 1 percent to 3 percent over the coming years, with a consensus of around 1.4 percent. The effect on growth in Europe is much more muted, at around -0.5 percent. The impact on US growth is also anticipated to be a fraction of a percent. None of these anticipated results are pleasant, but they are all manageable.
The “Leave” vote is historic in its political implications, and may represent the nadir of European dissatisfaction with austerity and immigration policy. Scotland, having just completed a referendum on remaining a part of the UK, has said the vote may have gone the other way if the Scots knew the UK would later vote to exit the European Union. The Welsh and northern Irish have stated that they want to remain part of Europe as well. Disintegration of the UK is a possibility. On the continent, there are vibrant far-right nationalist parties in France, Spain, Italy, Greece, and Poland, to name a few, who would love to have a vote on EU membership. As of this moment, none of these movements have the political power to force a vote, nor would the votes have enough support to pass. One wonders if, having seen the carnage visited on Greece, and initial market and world reaction to the British vote, many voters on the continent have the same fervor for separating from the EU now that they did a month or two ago.
For this reason, and the fact that it would be financial suicide for many European nations to sever from the EU, we do not believe this is a major risk at this time. Member countries cannot afford to tear up the favorable trading terms they have with other EU nations, much less trading terms to EU has drawn up with the rest of the world. Right now, Spain and Italy can readily access the debt markets, and pay less than the US, at 1.25 percent and 1.37 percent, respectively, on their debt. Debt service costs and budgets would become quickly unmanageable debt burdens if rates rose substantially, which they doubtlessly would upon exit. Capital would be much harder to access, and the drop off in economic activity from a decline in trade and economic uncertainty would be severe.
For these reasons and others, we believe the risk of other European Referenda passing are minimal right now, and ultimately the UK will wrest a few minor concessions or modifications from the EU and have a second referendum within the next few years. There is some precedence for this possibility; in 1992 the Danes rejected the Maastricht Treaty, and the Irish rejected the treaty of Nice in 2001 and treaty of Lisbon in 2008 by referenda. The world rolled on, negotiations were struck, and the Danes and Irish subsequently ratified said treaties.
Politics are volatile, and we will be on the lookout for a change in this assessment. If the recent pickup in growth continues or accelerates, reform pressures will abate someone.
How Did Markets Respond?
Although stock market moves were large, there was surprisingly little contagion or large market moves outside of the UK or Euro area. There is no evidence of a systemic threat to the world’s financial system or economy at this moment. Global stock markets fell 4.1 percent on Friday, and another 1.1 percent the following Monday. Losses were concentrated in Europe, with markets down around 11 percent over the two days. Japanese equities were down around 5.5 percent, and the US market declined 5.7 percent. Stocks in emerging markets were surprisingly behaved, declining only 2.3 percent. Investment spreads in bond markets were also well behaved. The Brexit impact was limited to UK and Europe, where it will be meaningful but manageable. The British pound dropped to a new 30-year low, losing over 10 percent. The dollar and yen strengthened. The star investment performers were sovereign debt and gold. Safe haven investments are up since the beginning of 2015, gold is up over 25 percent since December low; and the yen is up over 17 percent since the new-year. Yields on German Bonds are negative out to ten-year maturities. Over the last two trading days markets have moved up, recovering almost half of the Brexit losses.
What are the Investment Implications?
We believe that the Brexit crisis is no different from the myriad other crises we have experienced over the last thirty years. There is a short-term reaction — much of it borne of emotion and speculation, and then over the longer run markets adjust to fundamentals. It is important that your investment planning be geared to your objectives and grounded in long-run investment fundamentals, which at the moment look fine, especially outside the US. The financial media and industry needs crises; they are the fuel of the ongoing crisis drama, since the financial crisis is getting tiresome. Crises generate fear and concern, which prompt worry and encourage investors to take short-term actions, which may not be to the benefit of their long-run financial well-being. Individuals, especially those who pay taxes, are rarely well served by engaging in short-term speculative activity based on noisy media or financial prognosticators. In any case, we will remain true to our investment beliefs, (many of which are stated on our webpage: https://versantcm.com/wealth-management-counselors/) which include: Our clients stand ready to provide liquidity in times of distress with long-term funds. In other words, market distress is first viewed as a potential source of opportunity rather than a threat.
Before the GFC (Global Financial Crisis, from June 2007 to March 2009), market dislocations such as Brexit would have been looked upon by at least half of our clients as potential investing opportunities. Investor psychology has been shaded decidedly negative since that time, and most investors are scared and ask questions borne of fear. We believe that the GFC has scarred the investment psyche of many investors as well as the financial media. What passes for news in the present day focuses on the negative and what may cause the world’s next great economic crisis. It is much harder to keep a level head and keep a balanced view in light of all the negative noise.
We do not recommend any changes to your portfolios either before or after the Brexit vote. The first reason is that Brexit will probably not pass. As of the Tuesday before the vote, most polls showed the “Remain” vote with a slight lead, and market rallies echoed that sentiment. Almost all government officials and economists, not just from the UK but also around the world, supported the “Remain” vote. The referendum is only a non-binding referendum, not a legally binding vote. A parliamentary vote would be required to invoke Article 50 of the Lisbon Treaty, which deals with the process for exiting EU membership. It is far more likely that the EU would come to some negotiated solution with the UK over a period of years that would keep them in the union without upsetting other members too much. Indeed, Vote Leave does not want a formal Article 50 exit request. In the days following the vote, many UK citizens expressed surprise at its passage, and some who voted to leave have said they would not have done so if they knew the Leave vote would prevail. They call for preliminary negotiations with the EU, and will not accept free movement of labor as a condition of membership.
Investment markets have already reacted, at least to some extent, to the Brexit phenomenon. It is important to remember that markets are expectational; they do not necessarily look backwards or even to the present. They are interested in what is going to happen, and how future events will impact future cash flows. Think of it as the investment world’s best probability-weighted guess of how the future will unfold. This is how market prices are arrived at. We are not implying that current market and currency prices are perfectly forecasting the future, simply that the market makes the best “guess” about an unknown future. Anybody who buys or sells an investment based on what they think about the future is saying the crowd’s guess is wrong. This may be easier to do in times of high emotion, but the vast majority of the time successfully betting against market prices, and incurring attendant transaction costs and paying taxes on capital gains, is a very difficult road to success.
The table below shows investment returns for various stock markets, as well as the US stock market, for the past 12 months ending March 31, 2016. A market correction has been well underway since early 2015, and for peripheral Europe it is very close to a bear market. It is difficult to extract the anticipatory effect of Brexit on these results, as there have been other concerns, such as terrorism and slow economic growth, also affecting European Markets. Nonetheless, we are not in a situation where European markets have been consistently rising and are ready for a fall.
The table also shows Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE) as an indicator of market valuation (CAPE attempts to smooth out the effects of business cycles by averaging the last 10 years of inflation-adjusted reported corporate earnings, and then dividing by price, rather than the industry convention of using just the last twelve months of reported or operating earnings). The numbers show that equity market valuations in Europe are much lower than in the US. Indeed, they are low on a relative basis and an absolute basis. The UK market is valued at a CAPE multiple of 10.62; the long-run average for the US market is 15-16. Why would anyone incur the transaction costs and tax liabilities to sell out of a market that is priced so low? How would they know when to get back in? Surely the UK market and other European markets were anticipating some trouble already.
Not only that, but dividend yields in all the markets are much higher than ten-year bond yields, and dividends are only the portion of corporate profits that are paid out to shareholders. They typically don’t include reinvestment or profits used to buy back stocks. In other words, just the cash dividend returns in the world equity markets are superior to bond market and cash yields.
Given these market conditions, if I were forced to bet, I would be buying the UK and peripheral European markets and betting on the “Remain” vote, and a subsequent European recovery. If anything, the wide price swings are an opportunity.
Disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Versant Capital Management, Inc.), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Versant Capital Management, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Versant Capital Management, Inc. is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Versant Capital Management, Inc. client, please remember to contact Versant Capital Management, Inc., in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Versant Capital Management, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.
