Investor Implications Of The Brexit VoteSubmitted by Queen City Capital Management on June 30th, 2016
With the recent market volatility brought about by last week’s historic Brexit referendum in the United Kingdom, here are our thoughts and opinions concerning the referendum and the potential investment implications this vote may have.
Jeff Spitzmiller June 29, 2016
UNDERSTANDING THE EFFECTS OF THE BREXIT REFERENDUM
In spite of all the polls suggesting that the United Kingdom would vote to remain in the European Union (EU), the markets were caught wrong-footed following the referendum as the vote came in at 52% to 48% to leave. The effects on the markets were immediate. The British pound fell to a three decade low and European stocks suffered their worst two-day decline in more than seven years. Safe haven assets like government debt and gold rallied sharply. In general, stocks in the U.S. fell around 5% over the two-day period between Friday and Monday while European stocks fell over 10%. The markets had risen sharply for the week prior to the vote, however, as investors thought the vote would be to remain. Combine this with the markets gaining back around half of their losses since the downturn ended Monday and the net effect is that stocks are down only slightly from just a few weeks ago.
The referendum was primarily a rebuff of the political establishment and dissatisfaction with immigration policies. While the selloff has been painful in the short-term, this isn’t a repeat of the financial crisis. Stocks have just been repriced for a future when earnings will likely be weaker amidst the uncertainty. The UK’s exit and its effect on the rest of Europe will likely take years to fully play out, but it will negatively impact economic growth, primarily in the U.K. and Europe, as business spending slows and consumers become more cautious.
British Prime Minister, David Cameron, announced his plans to resign amidst the failed campaign to remain part of the European Union. New elections within the Conservative Party will likely be in September and his successor will be left with the task of potential succession. It’s important to understand that the vote was only a referendum and not binding until Article 50 of the EU’s Lisbon Treaty is invoked, and this will not happen until a new Prime Minister is chosen. At that point, in depth negotiations on Britain’s exit from and its future ties to the EU will begin, and they will then have two years to complete the process. Since this will be a slow process, there is a chance a case of “buyer’s remorse” could occur and a new referendum called. In addition, any change in the government if new elections are held, especially one more pro EU, could alter the plans for an exit.
If Britain decides to move forward and invoke Article 50, then there will be a list of things to watch that would affect the future of the European Union. This includes whether Northern Ireland, Wales and/or Scotland hold their own referendums on whether to separate from the U.K. and remain with the EU. In addition, how will the current leadership of the EU deal with Britain? Will they set a harsher tone to punish Britain in hopes of dissuading other countries from making the same attempt at exiting? The rise of various populist parties in Italy, Spain and France in particular will be monitoring the results closely. Or will they take a more conciliatory approach, which will minimize any disruptions that would negatively affect their economies and trade?
In spite of the many uncertainties on what the Brexit referendum will ultimately lead to, we believe there are a number of potential investment implications, including:
1) Continued volatility in the equity markets can be expected as the above mentioned events play out. This doesn’t necessarily mean the markets will move lower, just the ride will be a little bumpier moving forward. While valuation levels are now more attractive overseas amidst the selloff, the positive for the U.S. markets is that the majority of revenues generated by U.S. companies are domestic, and thus are more insulated from the events in Europe. We continue to hold to the belief that we remain in a bull market in U.S. equities, and although the expected returns of this asset class will be lower than the historical averages, we believe we are still a year or two out from a recession and thus a potential bear market, and in this scenario equities remain more attractive from a risk/return standpoint than fixed income. Certain segments of the equity markets, like income oriented sectors and companies, should hold up better in this environment.
2) The value of the U.S. dollar and other safe haven currencies like the Japanese yen and Swiss franc may rise further relative to the euro and British pound. While helping exports of companies with the weaker currencies, those companies in countries with an appreciating currency, like the U.S., would find further pressure on earnings as their goods become more expensive to overseas buyers. Central banks around the globe will continue to face further pressures to intervene and weaken their currencies to fuel growth.
3) The fall in yields on government bonds from already extremely low levels will likely continue in the short-term. The 10-year U.S. Treasury is now yielding under 1.50%. With similar government bonds in supposedly safe-haven countries like Germany and Japan in negative yield territory, there is more room for U.S. rates to fall, especially with the Federal Reserve likely on hold from any further rate increases for the remainder of the year.
4) Financial stocks around the globe will face further pressure on their profits as lower interest rates continue to make it harder for them to make money on the low spreads between deposit and lending rates. As we recently saw, banks were the hardest hit during the brief selloff. With that said this is not a Lehman moment (the collapse of Lehman Brothers and the negative affect it had on the global financial system), as most banks are better capitalized than they’ve been in years, and while profits might suffer, they should be able to handle market turmoil.
5) Slower global economic growth could put further downward pressure on oil prices, which have recently started to stabilize. While supply has started to slowly equalize with demand, any drop-off in demand will place further pressure on oil prices and oil producers.
There is still much uncertainty following the referendum, and further volatility can be expected as the markets dissect the changing political landscape. During the selloff, many asset classes were successful in their diversifier role in providing protection from the market turmoil. Gold, utilities, high quality bonds, and managed futures were some of the areas of the market that performed well during the volatility. While market returns in general are expected to be lower moving forward, there remain areas of opportunity that investors can capitalize on. Diversification amidst the uncertainty remains an important facet of successful investing.
This was prepared by Queen City Capital Management, LLC. a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Queen City Capital Management, LLC Form ADV Part 2A & 2B can be obtained by written request directly to: Queen City Capital Management, LLC 105 East Fourth St. Ste. #800 Cincinnati, OH 45202.
All opinions and estimates constitute the firm’s judgment as of the date of this report and are subject to change without notice. This is provided to investment advisory services clients of Queen City Capital Management, LLC. It is not intended as an offer or solicitation with respect to the purchase or sale of any security. Investing may involve risk including loss of principal. Investment returns, particularly over shorter time periods are highly dependent on trends in the various investment markets. Past performance is no guarantee of future results.
The information herein was obtained from various sources. Queen City Capital Management, LLC does not guarantee the accuracy or completeness of such information provided by third parties. The information given is as of the date indicated and believed to be reliable. Queen City Capital Management, LLC assumes no obligation to update this information, or to advise on further developments relating to it.
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© Copyright June 2016, Queen City Capital Management, LLC. All rights reserved. Updated 06/16.