You have heard the term for months; some investors had little idea what it meant, and most of the media talking heads downplayed it. Yes, I am referring to "Brexit," one of 2016's most annoying and overused terms that is an acronym for "Britain's exit" from the European Union (EU). We knew that the vote would occur in June, but whether it was wishful thinking, a "head in the sand" mentality, or just very poor polling data, few thought it could actually happen.
British voters, however had other ideas, and thumbed their nose at the EU. Prime Minister Cameron resigned, and on Friday June 24th, worldwide stock markets felt the pain. Thus ended the second quarter, on a down note, with major implications for the future. Or did it?
After a blistering couple of days on Friday June 24th and Monday June 27th, major markets found themselves in the grips of fear. Germany (DAX Index) had fallen more than 10%, France (CAC) was down nearly 10%, the U.K. (FTSE) was off nearly 6%, and the sympathetic U.S. (S&P 500) fell more than 5%. The dollar strengthened, and the British pound hit a 30-year low. What a way to end the quarter, another market Armageddon was surely beginning, and anxious investors, whose calamity anchor point is 2008, braced for the worst. Not so fast.
While the markets do not like surprises, as evidenced by the initial reaction to "Brexit", investors should have learned by now that markets also have a mind of their own, and their movement is nearly impossible to predict, especially in the short-term. Over the last three days of the quarter, many markets recovered. In fact, had you taken a week long nap, beginning on Thursday 6/23, and awoken at quarter end, ignored the headlines, and concentrated where markets started and ended during your slumber, you would have concluded that it was a very boring week.
Q2 in Review
Despite what was a shocking end, Q2 was much stronger than last quarter for many asset classes. Commodities were among the strongest performers following a terrible Q1. Most equity categories were in positive territory with the exception of Developed ex-U.S., which was down marginally. Emerging markets posted modestly positive returns, a huge improvement over Q1's terrible showing. Meanwhile high-yield debt was a big winner, up nearly 6%. Overall, it was a strong, albeit volatile quarter.
While "Brexit" was not the only news during the quarter, it certainly dominated, and ended up overshadowing one of the other major forces, that being the Federal Reserve's decision at its June meeting to hold interest rates steady. There was a lot of "Yellen" about the sharp slowdown in May hiring, and the central bank indicated that its pace for tightening rates will be muted in the coming years until economic growth is on firmer footing.
Looking Ahead… Trying To, Anyway
Despite the equity and credit markets quickly shrugging off the initial shock of Brexit (at least for now), the potential for longer term consequences is something we take seriously and view with great caution. We see strong evidence the coast is not clear given that the 10 year U.S. Treasury fell to a record low to end the week at 1.44%. The impact of Britain alone leaving the EU is small in our view, but the longer-term ramifications, i.e. if other nations follow suit, remain unclear.
In many previous commentaries over the years, we questioned the EU’s sustainability and had expected that its structure would change—the question was whether it would change radically, marginally or, simply, unravel and disappear. With "Brexit," our prognostication has started to become a reality and the risks of a contagion are now greater than they were pre-vote. Prior to the British referendum Europe already had its share of risk factors including high unemployment, massive debt burdens, and sluggish economies; "Brexit" just adds fuel to the fire and raises the specter of an unprecedented EU exit led by a country in the currency bloc—an event almost certain to send shock waves through the global financial system. We believe these risks are showing up more so in the rush to own the asset considered the world’s safe haven, the U.S. Treasury. This may be the ultimate "flight to quality."
One of the other unknowns relating to "Brexit" may have ties to a current U.S. phenomenon -that being the rising tide of populism and isolationism. Arguably, the British voted as they did with little regard for the potential economic implications of leaving the EU due to their frustration with economic stagnation and a general sense of their needs being ignored by the political elite. The referendum empowered the majority with an actionable voice. While immigration as a headline issue seemed to point to an acute drive to take control of the country’s borders, to this observer it appears to be a proxy for wanting more control over their lives. In our own country, the upcoming election may be a referendum on issues similar to what drove "Brexit." That election may also add further fuel to the volatility fire. The silver lining in the cloud, both here and in Europe, however, may be the potential for positive changes that will address social and economic issues plaguing many countries.
While we proceed into Q3 with a level of caution, we also believe that "Brexit" fallout could actually provide opportunities to add to risk assets that may have been, or will be over-punished as events in Europe unfold. We remain patient for those opportunities to present themselves. We also believe that the volatility about which we've sounded like the proverbial broken record over the past several quarters will only increase.
Fortunately, given our general view of capital market conditions and our thesis that markets had not appropriately discounted the risk of "Brexit," our portfolios were well positioned going into the vote and continue to be structured to address ongoing volatility and uncertainty.
As always, we will continue to monitor this situation, and will continue our efforts to manage portfolios ahead of any new developments, as we did prior to "Brexit" (see our previous blog). We apologize in advance if you begin to be bombarded with newer takes on the same theme; be it "Frexit" (France's exit from the EU), "Nexit" (The Netherlands), Hexit (Hungary), or "Auxit" (Austria).