BREXIT et al. – Q2 2016

BREXIT et al. – Q2 2016

Dylan B. Minor PhD, MS, CFP®, ChFC, CLU

Chief Strategist and Chief Investment Officer 

“I can never suppose this country so far lost to all ideas of self-importance as to be willing to grant America independence; if that could ever be adopted I shall despair of this country being ever preserved from a state of inferiority and consequently falling into a very low class among the European States.” King George III

Just before we celebrated Independence Day earlier this month, Britain voted for their own independence—their so called Brexit. The result was a bit of financial market turmoil. Déjà vu! In my last quarterly commentary I wrote about how the US stock market kicked the year off with a precipitous slide. The media was quick to remind us that we were starting out just as we did in 2008. And that year, after falling significantly in January, stocks ended the year at a 40-50% loss. Investors apparently agreed with the media’s warning: In January equity funds had a net outflow of over $20 billion. And year to date (through 7/13), equity investors have pulled over $50 billion out of stock mutual funds and ETFs.[1] Meanwhile, with all of these funds on the sidelines, US stocks have hit record new highs. For a recap of a broad swath of market returns see our review here. Before turning to our most recent Brexit turmoil, for context let’s review the significance of the UK and the European Union (EU).

As an economist, I am a proponent of the idea of an EU. In fact, the EU has many analogs to the United States’ Federal system. Just as our Federal government creates laws that supersede any particular state’s law, so too the EU creates laws that supersede each member state’s laws. The hope for both the US and the EU is to pass laws that help improve interstate commercial activity through standardization and liberalization. For the EU, this means creating laws that help improve the flow of capital, labor, and trade among the EU member nations.

The EU consists of some ½ billion people and is expected to produce $19.2 trillion of GDP (purchasing price parity (PPP)) in 2016.[2] For comparison, the US is expected to produce $18.6 trillion of GDP (PPP) this year. Meanwhile, China has become the largest economy in the world with almost $21 trillion of GDP (PPP) expected in 2016, supplanting the EU and the US, which now hold the number position two and three, respectively. All the while, the UK generated GDP of $3.7 trillion (PPP) in 2015. Thus, if the UK successfully completes BREXIT, this means both almost 20% of the EU’s economy will no longer be governed by the EU and the US will rise to become the second largest world economy.

Although I (and much of the world) was surprised by the Leave vote triumphing, the UK has a rich history of individualism, including how it relates to the EU. Indeed, the UK never chose to join the EU currency. The UK also withdrew from an EU monetary mechanism in 1992. So in this respect, if you were going to have predicted a nation to leave the EU, the UK would not have been a bad guess (though I again thought they would remain).

So what are the economic consequences of the UK leaving the EU? Since the UK contributes less than .7% of the US GDP, the expected impact on the US economy is close to zero. However, Goldman Sachs forecasts that the EU’s economic output will be shaved by .5%, and the UK will lose some -2.75% off economic output; this will put the UK in danger of entering a recession this next year. However, none of these scenarios deserve the category of catastrophic, in my view. Financial markets also ultimately reflected this perspective. The UK stock market, as measured by the largest 100 UK publicly listed companies (i.e., FTSE 100), fell close to 6% only to recover two-trading days later. Ironically, the US stock market (i.e., S&P 500) took more than an additional week compared to the UK to fully recover its 6% loss.[3]

Meanwhile after the Brexit vote, non-Omega investors yanked a net $10 billion from equity funds ending the week 6/29 upon Brexit. After markets recovered, they added $9.4 billion net to equity fund ending the week of 7/13. This means that while stocks ended up 2% when it was all said and done, the average investor ended down about 5%, or a difference of 7%.[4]

So what happens next? There is a long road to complete the separation of the UK from the EU. First it must trigger Article 50, which will then start a 2-year negotiation period between the UK and the EU. The new prime minister of the UK, Theresa May, who had pushed for the UK to remain has said Article 50 will not be triggered until 2017. Thus, we are over two years away from a completed separation. This is, of course, an eternity in politics and could possibly even usher in a Breversal, with the UK deciding to ultimately remain. Nonetheless, my best guess is that they will complete the transaction. May has said, “Brexit means Brexit” and she appointed Boris Johnson, who supported the Leave campaign, as the new foreign secretary.[5]

Assuming that they avoid a Breversal, the most important issue is how the UK chooses to engage with the EU after exiting. One option is to create agreements with the EU similar to the Norway, which, although not an EU member nation, has close and arguably effective ties with the EU. The other extreme is for the UK to become like say Russia. My bet would be on a Norway-like approach. And it seems financial markets feel similarly based on current asset prices. Nonetheless, there still remains another risk in addition to the UK’s degree of independence: If the UK’s independence encourages other EU nations to leave, this would prove more damaging. However, I currently see this as a low probability outcome.

In sum, it does not seem that (for now) we should be worrying much about Brexit. However, there are, of course, always more things to worry about. Probably the next item looming the largest is the upcoming United States presidential election. Indeed, I had one Omega client recently say they are concerned that if Clinton is elected, the economy will fall part, whereas another client said if Trump is elected, the same result will come to pass. Both wanted to place their entire portfolio in cash.

So who will win? A recent poll by Reuters (ending 7/22) showed that the two candidates are at a dead tie, in statistical terms. Of course, the US is a republic and so we really need to consider the Electoral College rather than the popular vote. Taking this approach, the contest is still undecided. However, if we turn to the betting markets, which do take into consideration the Electoral College, Clinton has the advantage. Nonetheless, whoever wins, it turns out that (at least historically) it doesn’t matter for the market’s returns. Research by Goldman Sachs shows that regardless of which party holds the Oval Office, what matters is which political party controls Congress. After all, Congress sets the laws of the land. To be sure, the president can veto laws, press Congress to create laws, and issue executive orders. However, these are generally not enough to destroy the US economy. Goldman Sachs found that when Congress is controlled by Republicans US stocks average 14.5%, whereas when Democrats controlled Congress stocks averaged just 8%. However, as with many of these kinds of factoids, these differences are not statistically significant, which means that although the average is different we cannot rule out that it is different solely because of luck. In short, there are many forces that determine our fortunes, and Congress and the President are not as important as many other forces.

This is the good news. The bad news is that it’s really hard to predict which forces will matter in the future and how they will matter for any given period. Since I am not confident in my ability to do so, we at Omega have embraced our States of the World Wealth Management® process that instead starts with the end in mind. That is, while we do not (or at least I do not) know what will happen to US stocks, for example, in the next 12 months, we do know they will end up, down, or the same. So instead of predicting which of these states will occur 12 months from now, we partition your portfolio to include some assets for each potential state. For example, our Total Return® strategy can help during a flat US market, whereas Managed Futures have a long history of helping during precipitous market falls, and all the while stocks exposure with a midcap bias helps capture a greater share of stock market upswings.

Nevertheless, even with a sophisticated investment policy, one of the greatest challenge in all of this is to simply stay the course—for us, to tie our wrists to the mast of our ship, as did Odysseus, so that when we hear the siren’s (media’s?) call we stick to our course and don’t follow the masses that jump ship. At Omega, we take very seriously our charge to help you stick to your investment policy in good times and bad times. Over the 21 years I’ve been in practice, remarkably, I have seen sticking to one’s plan to be one of the most important factors of financial success.

In addition to a sound investment policy and adhering to it, another way to help stay the course is to identify any positives from a given crisis. In this spirit, I leave you with this suggestion for the quarter: the way for Brexit to have the most positive impact on your life is now to take a trip to the UK. The UK—the land and its people— are a delight to visit. And based on the current exchange rate, your trip is now being offered at a 15% discount! Whatever the case, I hope that you have wonderful Summer, whether here or there!





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[1] source: ICI and authors estimates

[2] IMF estimates for all GDP values

[3] Author’s estimates

[4] Source: ICI, which covers 98% of all mutual funds and ETFs