If you’ve been wondering where the next market shockwave might come from, I think you now have your answer. Last week, Britain voted in a referendum to leave the European Union – a move termed “Brexit” by worldwide media. The outcome of the vote came as a surprise to just about everyone. Leaving the EU is likely to isolate Britain economically and do more harm than good. The markets reacted in kind, with the S&P 500 falling over 3% on Friday 6/24, and then 1.8% again Monday 6/27. Overseas markets fell even more.

But despite the harsh sell off, Britain doesn’t constitute a large percentage of trade, both with the U.S. and worldwide. While the Brexit might have other implications about the long term viability of the EU, there is not much threat to financial assets and the economy at large. In short, the media and markets have overreacted.

This quarter’s investment insights will be devoted to the Brexit. We’ll cover what exactly happened, why it happened, what to expect going forward, and how it impacts various asset classes and your portfolio.

But before we get started, I’d like to mention that I’ve created a new website called Above the Canopy. My objective with Above the Canopy is to supplement my work at Three Oaks Capital and connect with clients, colleagues, and friends on a more informal basis. On the site you’ll see posts on financial planning and investment management, and the blog format allows me to inject more personality (hopefully) than you’d typically see on a formal corporate site like www.3oakscapital.com. Be sure to visit and subscribe at http://abovethecanopy.us, and if you have any feedback I’d love to hear it.

 

Brexit: What Happened?

To start, let’s review what the European Union is exactly. After World War II, European countries came together to discuss how they could prevent more violence and another catastrophe in the future. The thought was that if they co-operated on many different levels (trade, transport, consumer rights, etc.) they would be less likely to go to war. A partnership was born from this idea – the European Union, or EU.

Today the EU consists of 28 different countries. And while it does have the Euro as its own currency, only 19 of the 28 use it formally. The other 9 have retained their home currency, including Britain. In its current form, the EU agreement includes the free trade of goods and free travel of people. By reducing the barriers to international trade, the region acts more like one collective state. This system is more efficient operationally, and increases the output and economic strength of the entire region. Because of this, the EU has become known as a “single market.”

Over the last 7-10 years, there’s been growing frustration within Britain about the state of their economy and job market. And especially amongst younger people, the EU has become a scapegoat.

For Britain, membership in the EU comes with mandated regulations and billions of pounds of operating fees every year. Britons who voted to leave (the “Leavers”) believe that the costs of membership outweigh the benefits, the EU is holding Britain back, and the country will be better off on its own.

Of the mandated regulations, the main sticking point had to do with immigration. One of the core principles of the EU is “free movement,” which allows travel between EU countries without needing a visa. The Leavers are frustrated with the massive amount of immigration to Britain, and want to control their borders. The only way to accomplish this was to leave the EU entirely.

The idea to leave started off as an extreme longshot. It snowballed over time though, and finally gained enough traction to trigger a referendum. The vote was tabbed as the country’s most important in over 50 years, and saw a turnout rate of 72%. For comparison, in the 2012 U.S. Presidential election only 53.6% of voting age citizens participated.

Prior to the vote, numerous world leaders went public and urged the British people to vote to stay. Heads of the International Monetary Fund, NATO, and expert economists all warned against the economic repercussions of leaving the single market. Going into the vote, most everyone saw a Brexit as a gigantic mistake and extreme long shot to pass. But it did, as you know, with the Leavers prevailing 52% to 48%.

 

What Happens Now?

Now that Britain has voted itself out, it needs to plan an exit strategy. This will determine how closely the country will be aligned with the EU. And at this point, two options have emerged as the most likely. Neither one is particularly good for the prosperity of the country, though.

The first option would retain some ties to the EU, and would be similar to Norway’s relationship. Britain would become a European Economic Area (EEA), which would allow some free movement in trade. In exchange, the country would be required to contribute to the EU’s operating budget (albeit less than they currently do) and still allow the free movement of people. Although this issue was a sticking point in the decision to leave, this arrangement would let Britain retain access to the single market. This is the better option from an economic point of view, and leaves the country less isolated.

The second option is more radical: Britain would step away from the EU entirely. This would allow the country to impose immigration restrictions as it wishes, but it would also be a total outsider to the single market. This route might appease the popular vote because of the immigration flexibility, but it would likely have more serious economic consequences. By being outside the single market, international trade would be far less efficient, tariffs would likely arise, and the country’s output would suffer.

Britain’s exact route will depend on a few factors. Most experts believe that the country will invoke “article 50” of the Lisbon Treaty. By doing so the remaining 27 countries would have a two year window to decide what type of trade deal to offer – done by majority rule. If Britain does invoke article 50, the most likely offer from the EU would be to become an EEA like Norway. If the window closes before a deal is reached, Britain would exit entirely (option number two). The window can be extended though, by a unanimous vote.

There’s no guarantee the country will invoke article 50 however. Those who voted in favor of leaving will likely be reluctant to give the remaining 27 countries so much control of their destiny. Britain’s current Prime Minister, David Cameron, will be stepping down later in the year as a result of the vote. And if his replacement is in favor of secession, he could easily spurn cooperation with the EU entirely. Again, this path would mean option 2, where Britain secedes entirely.

British Pound vs. U.S. Dollar: 6/22/16 - 6/29/16

The whole idea of leaving the EU was brought forth by a youthful, anti-establishment type movement. If this faction is successful in a complete secession, Britain will become a far more isolated economy. This means fewer jobs, lower tax receipts, and harsh(er) austerity measures. The British pound will fall further in value (it lost more than 8% against the dollar overnight after the Brexit vote).

How this plays out is a political question and anyone’s guess. My sense is that the decision will come down to how strongly the Leavers feel about immigration reform. They’re likely to “come to their senses” over the next few weeks and realize the potential economic damage an outright secession will cause. If the free flow of people is something they can live with, article 50 and exiting as an EEA should be an amicable solution. If not, they’ll be headed toward more isolation and continued economic problems.

 

What Does This Mean For the U.S.?

To be honest, not as much as the media would have you believe. Britain only accounts for 3.1% of the U.S.’s total exports. A slowdown of a few points in British GDP won’t make much of a dent in the U.S. economy.

Furthermore, the trade barriers between the U.S. and the European Union are quite low. We are both in the World Trade Organization, and also have a US-EU “open skies agreement.” This allows airliners to fly freely between countries, which is beneficial for shipping. But the fact that Britain is now independent of the EU doesn’t mean that they’ll put up walls and stop trading with other countries. Our trading relationship with Britain will continue and we will remain allies. The Brexit will mean slower economic growth for the Brits, but it won’t have much effect on us.

 

 

If there is an impact on the U.S., it could be our monetary policy. Janet Yellen and the Federal Reserve Board have signaled for most of this year to expect at least one more hike in the federal funds rate this year as the economy continues to improve. Thus far in 2016, their only hesitation has been due to “global economic pressures.” This is a vague statement, but calculated. Yellen wants to be transparent about their decision making, but not so specific that it spooks the markets into a panic. I’m a believer that this statement was a reference to sub-zero

interest rate policies in the EU and Japan and debt problems in China, but we can’t be sure. At any rate, the Brexit is another “global economic pressure” the Fed must account for. Which could mean that they postpone the next rate hike. RBC Capital, for example, expected four rate hikes in 2016 as recently as January. Now, the firm expects the next hike to be delayed to mid-2017.

 

What Does This Mean For Europe and the European Union?

According to the Economist, the rule of thumb is that whatever the reduction in Britain’s GDP growth, Europe’s economy will suffer a drop of about 50% as much. Needless to say, Europe’s economic growth will slow a bit. The larger long term issue is what the Brexit implies about the viability of the European Union. Britain is the first country to leave (save for Greenland, but they are technically part of Denmark). This is a chip in the armor of the EU, and it may be a slippery slope toward more departures. Italy has its own referendum coming up, and confidence in the EU has been waning in France for years. Depending on how Britain handles its exit, they might be setting an example for other countries.

A full dissolution of the EU is still very unlikely, but it would have a devastating effect on smaller countries. Britain is a relatively large economy compared to the other 27 nations, and it never deviated from using the pound. Smaller, more fragile economies like Greece would have severe problems as a stand-alone economy. It would be forced to revert back to the drachma, which would be extremely weak in international trade.

 

What Does This Mean For Stocks?

The immediate fallout from the Brexit was swift – but also a knee-jerk reaction. CNN reported that a record $3 trillion was wiped out from global markets in the two days immediately following the vote. This left investors fleeing for the safety of government bonds, which rallied significantly. Currently the yield on a ten year U.S. Government bond is 1.46%, and continues to creep toward the all-time low of 1.38% set in July of 2012. Remember – as bond prices rise, their yield drops. Yields on the sovereign bonds of Germany, Japan, and Switzerland ventured even further below zero.

Despite the recent sell off, the outlook for U.S. stocks really hasn’t changed. Corporate balance sheets are strong, interest rates are still low, and our economy is still

projected to grow at a 2.5% annual rate this quarter. Additionally, U.S. stocks are more insulated from the world economy than any other country. According to Morgan Stanley, American companies generate 70% of their revenue right here in the U.S., compared with 58% in Japan and 49% in Europe.

Another way to put this is to say that “the fundamentals remain strong.” If you watch the financial media you may have heard this phrase before. “Fundamentals” are analyst-speak for data that could be expected to impact the price of a stock. Factors like cash flow, revenue, return on assets, and profit margins are all considered fundamental indicators. In short, the Brexit hasn’t affected the fundamentals of U.S. stocks.

Abroad the situation is similar. Britain only accounts for 3.9% of the world’s total output, meaning that a Brexit slowdown won’t put a huge dent in global production. There are a few economies in Southeast Asia with strong historical ties to Britain. Apart from that region, the rest of the world should be left unscathed.

All in all, the initial shock from the Brexit should wear off soon and have little long term effects on stocks. Investors who own shares in British or European countries might consider paring down their allocation. But for most, the best decision will be to continue a steady path forward.

 

What Does This Mean For Bonds?

Stocks look even better when compared to bonds. As I mentioned before, the initial shock of the vote to leave caused a slight panic in the markets. Investors sold off stocks, and ran toward safer investments like U.S. government bonds. This “flight to quality” (more analyst- speak) is why the 10 year U.S. government bond yield to fell so far.

If 1.46% seems extremely low, that’s because it is. Right now the dividend yield on the S&P 500 is 2.2%. Moreover, 60% of its individual constituents are yielding more than the 10 year U.S. government bond. In short, the feeling of safety that comes from investing in government bonds is very expensive right now. This is true in other countries too, not just the United States.

Aside from government debts, other credit qualities have fared differently. High yield debt and preferred stock prices in particular have fallen. High yield debt tends to be vulnerable to market swings for two reasons. First,

the fact that a bond issue is considered high yield means that the issuer is more likely to default if times get tough and the economy slows down. Second, high yield bonds typically have lower liquidity than other bonds. So during market sell offs, investors often look to cut exposure to high yield bonds. And their shallow markets add fuel to the fire.

Preferred stocks, on the other hand, are most often issued by banks and other financial companies. For this reason the sector is concentrated in the banking industry, with financial issuers making up over 70% of the BofA Merrill Lynch Fixed Rate Preferred Index.

Coincidentally, financials were one of the hardest hit sectors during the selloff. Banks like RBS, Barclays, and Lloyds banking group have significant exposure to the U.K., and their preferred shares suffered accordingly. Going forward, I think we can expect more volatility from both high yield bonds and preferred stocks. For investors reaching for yield, be sure you’re comfortable with this scenario. Investment grade corporate bonds present a much more stable opportunity – even if the yields are a little lower.

 

What Should You Do Now?

Unless a large portion of your portfolio is allocated in British and European equities, I don’t believe the Brexit warrants a change in your investment strategy. The markets have already rebounded nicely in the few days after the initial sell off. I believe this will continue as the world realizes that for the most part, it doesn’t matter to the U.S. or global economies whether Britain is in or out of the European Union.

If you’re concerned about your portfolio or would like to talk in more detail, feel free to give me a call.