The British Are Leaving!  The British Are Leaving!

Following months of debate on the potential impact and ramifications of membership in the European Union, the people of the United Kingdom voted last night to ‘leave’ in a historic referendum.  Global markets have responded significantly to the downside, a move exacerbated by poorly interpreted polling data as well as surprising complacency moving into an asymmetric event of this magnitude.

Immediate Consequences

Given the nature of last night’s unexpected “Dewey Defeats Truman” vote outcome to leave, we expect widespread weakness in global equity markets, with the U.K and Europe at center stage.  Safe haven assets such as bonds, the U.S. dollar and precious metals will continue to rally as a near-term ‘flight-to-quality’ move unfolds in the days to come.  Additionally, we expect significant currency adjustments, with the Euro weakening towards U.S. dollar parity and the British Pound weakening dramatically against all worldwide currencies.

While the United Kingdom will likely slip into recession territory in the wake of this decision, as financial sector employment migrates out of London and the country embarks on a multi-year renegotiation of their trade agreements, the intermediate outcomes are likely to be far less severe than the recent political fear-mongering has projected.  Meanwhile, longer-term growth implications will be dependent on trade negotiations – but given the sizeable offset from the devalued British Pound, as well as savings from ending their contributions to the EU, economic repercussions are potentially more limited than many believe.

Importantly, we do not see this event as a “Lehman Moment” as some have postulated.  The direct leverage conditions for a financial contagion are simply not present.  However, we are closely monitoring the financial condition of European banks, several European peripheral country bond markets, and any secondary effects that may unfold in the currency markets, specifically from an unexpected devaluation of the Chinese Yuan.  Finally, while markets will fluctuate in the days ahead, we do expect continued and highly coordinated central bank liquidity and easing programs, designed as countermeasures in the immediate term to help stabilize and calm markets.

Ahead of this announcement, Sand Hill Global Advisors’ investment team adopted a more conservative stance in our client portfolios.  This decision was predicated on our concern over how the markets would react as they approached the Brexit vote as well as our concern (at the time) over potential interest rate hikes by the Federal Reserve.  As a result of these concerns and recent market appreciation, we pared back our exposures – and importantly, took steps to directly reduce exposures tied to European equities.

Long-Term Considerations

The long-term impact on the European and U.K. economies will remain an area of uncertainty that will depend on the variety of factors and the terms of their new agreement with the European Union.  However, the uncertainty around trade and the timing of the U.K.’s departure will likely be a negative for business and consumer confidence as decisions around hiring and capital investment will probably be delayed.  As a result, we suspect these detrimental effects to cause at least a low grade recession for the U.K.  Importantly, from an operational perspective, having retained their own currency and central bank (the Bank of England), the transition risks are mitigated to some degree.

Overall, we expect the impact from Brexit to create a modest headwind to economic growth globally, with the European Union suffering disproportionately.  Domestically, U.S. multi-national corporations will add a strong dollar to the list of headwinds for earnings in the coming year.  Yet we foresee the U.S. and China as continuing to be the two economic engines pulling global growth forward in the coming year, albeit at a moderate pace.  We estimate economic growth to be approximately 0.5% lower (placing average GDP gains at around 1.5% growth) in Europe and just fractionally lower than the 2% intermediate trend in the United States. A strong dollar could also contribute to lower oil prices, which would have a mixed impact on the economy as fewer energy and industrial-related jobs are created, but consumers save on lower energy costs.

Perhaps most importantly from an investment perspective will be the question of whether we are starting to see the first crack in the globalization trend.  Questions will abound on the power of various nationalistic movements throughout Europe and whether other member states will seek a similar referendum.  The long-term viability of the European Union will be center stage as a result. Additionally, if the Euro loses its diversifying reserve currency status, the dollar will continue to rally over time, which may become problematic.  Finally, pundits will link the outcomes in the U.K. to other anti-establishment movements around the world and what ramifications this vote will have on the U.S. presidential election, among other important storylines.

The question of the ‘Brexit ripple effect’ and its impact on the globalization trend will likely define much of the year to come.   Overall, a rise in nationalism and protectionism is generally associated with slower worldwide economic growth.  Additionally, slower economic growth could subsequently contribute to the global ‘race to the bottom’ on currency devaluations, an additional detractor to overall economic growth.  While we see limited direct financial contagion risks from this announcement, longer-term, as articulated here, we can foresee a possible cycle unfolding that could ultimately contribute to tipping the scales towards a global recession.  For now, that concern remains distant.

Seeking Opportunity in Market Turmoil 

In the current investable time horizon, our view remains that after a seven year economic expansion, we have entered the late economic cycle, a period of slower growth and lower returns characterized by slowing productivity and investment – a positive if uninspiring environment.  Brexit, like China or the Federal Reserve or the price of oil over the last year, represented a market ‘tail risk’ that has come to pass.  While Brexit introduces new uncertainties into the investment outlook, we believe the bear case for worldwide growth in its aftermath might be overstated.

It is important to note that while the dust has not yet settled, we will continue to execute in a disciplined manner and with a long-term view, focusing on attractive opportunities as they present themselves.  That discipline is what led to our more conservative positioning move into this asymmetric event – and it is that discipline that led to our contingency planning around what to do in the event the U.K. voted to ‘leave’ over the last several weeks.

Specifically, we are concentrating on: (i) taking advantage of the dislocation in the markets and the price opportunities observed in certain securities and asset classes; (ii) maintaining our commitment to a positive, if low growth, economic environment; (iii) focusing on assets that are negatively correlated to the dollar, such as many international and emerging market strategies as well as many commodities, which will likely come under near-term, and perhaps undue pressure; and finally (iv) continuing to emphasize higher dividend paying strategies, particularly should they come under pressure, making them even more attractive relative to the current yield on the 10-year Treasury bond.  Ultimately, we expect the global recovery will continue to trudge forward and this particular geopolitical crisis to calm in the weeks ahead.

Meanwhile, we will be patient and pick our spots.  This historic Brexit vote certainly does not mean the whole year is a washout or that you should jump to the sidelines.  We don’t see this vote as derailing the bigger picture and have identified positive catalysts in the year ahead once the dust settles, including: (i) an end to the long corporate earnings recession which, even with the dollar headwinds, will improve in the back half of the year; (ii) a Federal Reserve that will likely go on hold on interest rate increases for most of the year, maintaining an accommodative environment for a longer period than otherwise expected, and (iii) simply the resolution of the noise of the moment, which will fade as investors get more clarity and can quantify the new world order more succinctly.

We hope this update helps put the current state of the markets, the economy and your portfolio in better perspective.  Please don’t hesitate to contact us to speak specifically about your own portfolio and strategy.

– Your Sand Hill Team