The market impact of “Brexit”, a national referendum on June 24th in Great Britain, was immediate and severe. Stock markets sold off dramatically in response to an extremely large devaluation in the Pound Sterling. A flight to safety ensued with the US Dollar, Gold, and US Treasuries rallying in response. Brexit created a surge in volatility in a quarter that had been subdued in terms of volatility and quite positive in terms of performance. The heightened volatility reflected uncertainty, and the market began to assign probabilities for a further dismantling of the European Union.
The mechanism of leaving the European Union (i.e., Brexit) will be a process, and that process could require up to two years. Thus, the fundamental economic impact of Brexit remains far from clear. Additionally, the Brexit vote on June 24 was not binding. The UK Parliament will need to follow through in an official manner (known as invoking Article 50 of the EU’s Lisbon Treaty), and such action is not expected until the fall. News reports indicate mass confusion over the vote itself. It remains possible, therefore, that the final outcome could differ greatly from the promises made during the campaign.
The UK is an important participant in the global economy, especially in the banking sector. However, as the 5th largest economy in terms of GDP, it is only slightly larger than California. The net economic impact on the US should be minimal as exports to the UK are only 0.7% of GDP. Moreover, only 3% of S&P 500 revenues are derived from the UK. For these reasons, we urged clients to avoid panic in our June 24th communiqué. At this point, we feel vindicated as the markets have already recovered most of the losses suffered in a vicious two day sell off.
Many commentators immediately drew comparisons with the Lehman bankruptcy of 2008. The only similarity between the two, in our view, is that both outcomes were unexpected. Unlike the Lehman debacle, Brexit is not a one-time event with massive repercussions for the global banking system. Brexit will be a slow and arduous process, and the markets will have time to adjust to a new set of policies.
For some time, Patten & Patten has maintained an outlook for “lower for longer” with respect to interest rates. The uncertainty associated with Brexit will likely preclude rate increases by the Federal Reserve. In fact, the market anticipates the opposite could occur – i.e., additional monetary stimulus from the European Central Bank and others. We have also advocated an emphasis on domestic business models and companies that benefit from a stronger Dollar. Recent global developments support that strategy.
Year to date market leadership has been provided by defensive sectors, particularly those with attractive dividend yields. We expect this to continue as investors seek current income not available in the bond markets. We also believe that market events like Brexit offer opportunities to accumulate high quality securities that are sold in an indiscriminate manner. Long term, it is our belief that active portfolio management guided by the style, strategy, and process utilized by Patten & Patten will be well rewarded.
It is nearly certain Brexit will contribute to economic weakness in the UK and the EU, but the risk to the US is significantly lower, unless there is a loss in consumer confidence. The next few months are likely to be characterized by periodic surges in volatility, and it is possible that Brexit could result in economic weakness both in the US and abroad. We, therefore, intend to remain vigilant, but as of this writing, our outlooks for the markets and the economy remain positive.