The surprise Brexit vote has resulted in a sharp sell-off of equity markets globally
The declines, however, have been remarkably orderly with markets moving mostly sideways after initial drops
We do expect continued volatility in the coming weeks as markets assess the impact of the U.K. vote
Generally speaking, our portfolios have been underweight Europe for some time and we anticipate they will continue to be for the foreseeable future
The UK’s vote to leave the European Union (EU) has sent shock waves through the capital markets throughout the day today. The 52%/48% vote to leave the EU was a significant surprise, as most polls had the “remain” camp winning. Prior to today, world equity markets were largely up over the past week reflecting a similar “remain” outcome. Importantly though, while today’s moves were sizeable, with European stock markets down 10 to 15 percent in U.S. dollar terms, U.S. equities held in well on a relative basis. The S&P 500 Index, as an example, dropped about 3.5 percent Friday, but was still hovering within its 100 point trading range over the last several months.
On balance, our underweight to European equities has served us well in this environment as have our overweight to high quality lower-volatility and lower-beta domestic equities and a more cautious underweight allocation to emerging markets, resource entities, and inflation-hedging strategies. We continue to favor this course of action.
The Global Impact | Contagion or Containment?
Despite the results of the vote in Europe, it is important to remember that the U.K. represents just two percent of world growth and the full Eurozone accounts for only about 16 percent of the world’s economy. Risks of a broader impact of the U.K. vote are significant, and the fear of market contagion to the U.S. has increased. However, we believe the true risk to economic contagion in the U.S. is still extremely low. If U.S. exports to Europe dropped 5 to 10 percent it would equate to just a rounding error for U.S. real GDP. Domestic-focused U.S. companies should weather the storm that is brewing in Europe better than non-U.S. entities.
The political consequences could turn out to be significant not only in the U.K., but elsewhere in Europe where key elections will take place beginning this weekend in Spain and culminating with the German election next summer. These political consequences will likely have economic and market repercussions. Anti-EU views are rising in many countries including now Austria and Germany — and this goes beyond the battle on immigration issues. This warrants increased caution towards this region of the world as well as those countries and companies that are closely tied to Europe. Resource providing companies and emerging economies in Eastern Europe could also be vulnerable. The vote in the U.K. appears to be the start of the next chapter that is now challenging the structure of the European Union which adds to risk and still favors an underweight to the public markets in Europe. European currencies are likely to continue to weaken reflecting greater political uncertainty and risks, combined with more challenging near term economic conditions including a return to recession for several countries. Ultimately, a weaker currency is likely to be combined with more fiscal and monetary policy stimulus to eventually provide a boost to economic activity, but this process is likely to take months or even years to unfold and it pays to be patient and a bit late, rather than early and wrong.
Where to Deploy Risk Assets
We and our managers continue to see opportunities in domestic high-quality U.S. companies with strong cash flows, earnings, and dividends secured by earnings that should weather well in this difficult environment. Several domestic sectors may also receive support from the increased likelihood that interest rates will stay lower for longer. Net, we continue to favor an overweight to domestic-focused low volatility and low beta stocks and an underweight to Europe and many areas of the emerging world.
We are looking for opportunities to buy assets at more favorable valuations in the coming weeks and months, with the turn likely to take place first domestically and then eventually internationally. In the interim, the scarcity and demand for capital in many areas of the world may plant the seeds for investment opportunities from private sources that can be the provider of liquidity and capital in a more challenged world at more favorable entry valuations.
Guidance for Long-term Investors
As we have stressed in the past this is likely to be a low return world with more volatility, and many of our client institutions will be ending their fiscal years this month or taking a mid-year assessment of their fiscal condition. In this context it is important for investors to revisit their asset allocation, broader investment policy statements, and spending policies.
While human behavior often conditions us to “do something” in response to external stimuli, the most important guidance we offer clients is to be patient and stay the course. In counseling our clients not to focus inordinately on short-term market swings, we do recommend that you plan for the challenges of tempered returns over the next five years. Believe in your policy portfolio and your Investment Policy Statement (IPS); however, revisit your assumptions and make sure that your IPS accurately reflects your risk tolerances and goals. An effective IPS is a dynamic investment framework to guide your decisions through market cycles. It should be flexible, but with sufficient rigor to protect against the temptation to over react and “trade” out of down markets.