Bronfman Rothschild 2016 Q2 Review: “So What Happens Nexit?”
In a referendum held in late June, after over 40 years in the European Union (EU) and its predecessor organization, the European Economic Community (EEC), the voters of the United Kingdom (UK) surprisingly decided to exit. This Brexit (“British exit”) decision roiled global markets (stocks around the globe dropped 5%-10% while “safe” assets such as bonds and gold strengthened) and caused the British pound to fall to its lowest level in decades.
The impact on global markets of this vote was probably a bit disproportionate to the relatively small scale of the UK economy in global terms. To give some context, the UK represents approximately 3%-4% of global gross domestic product (GDP), so not particularly large. In fact, the State of California has only a slightly smaller GDP than the UK.
So why the panic? Although I cannot give you a definitive answer, the combination of low investor confidence globally and the uncertainty related to the UK and the EU as a whole moving forward did not help. As an aside, the best additional terms I have heard for other nations leaving the EU are: “de-Portugal”, “Ital-leave”, “Czech-out”, “Oustria”, and “Fin-ish.” Who says we don’t have a sense of humor in the finance business?
So what happens next? Well, the UK will remain a member of the EU until parliament invokes Article 50 of the Lisbon Treaty, which starts the process for negotiations with the EU. Anything after that is a matter of speculation, but it does appear that the UK has a number of options:
- Remain in the EU by either ignoring the referendum or holding an additional vote
- Act like Norway and seek entry into the European Economic Area (EEA) and European Free Trade Area (EFTRA)
- Act like Switzerland and seek trade and investment agreements with member nations
- Act like Turkey and join the EU customs union
- Negotiate a free trade agreement with the EU
- Withdraw from the EU and use World Trade Organization rules to obtain most favored nation trading status
Regardless of the path chosen, any final resolution will most likely take a number of years.
So what does this mean for all of us? Well, it is obvious that political risk is on the rise and that voters are dissatisfied with the status quo and are willing (maybe even eager) to entertain voices outside of the political mainstream (Donald Trump, Norbert Hofer, Pablo Iglesias Turrión anyone?). It is also possible that the Federal Reserve will be even more cautious in raising interest rates in this uncertain environment.
The next several months should bring some additional clarity regarding these issues, but as is often the case, conventional wisdom is often contradicted by the following day’s events.
The Markets – Excuse Me, I May Have Misplaced a Former Empire
It is safe to say that Brexit caught many by surprise. It is also safe to say that even ones who did their scenario analysis of “what if they do” got some of the calls wrong. The one universally correct was that the British pound would sell-off significantly, which it did by more than 10% against the dollar after the vote. Some less successful calls included a mass sell-off in UK equities (FTSE 100), which actually finished the quarter 200 points higher than where they were the day before the vote. Regardless, volatility abounds.
For the quarter, US large company stocks (represented by the S&P 500 Index) rose 2.5% while US small-mid company stocks (represented by the Russell 2500 Index) rose 3.6%. International stocks (represented by the MSCI ACWI ex US IMI Index) fell 0.7%, while emerging market stocks (represented by the MSCI EM IMI Index) broke just above even at 0.6%. Underneath those fairly tepid numbers came significant dispersion. Italian stocks fell 10% during the quarter, while Brexiting UK stocks fell less than 1%. On the opposite side of the world, where Olympic unpreparedness and Presidential impeachment dominated headlines, Brazil stocks managed to rise nearly 14%.
The rush for safety through the narrow Brexit door helped core fixed income investments rally domestically and overseas. The Barclays Capital US Aggregate Bond Index rose 2.2% for the quarter, most of that the last week of June. Abroad, despite more than a third of foreign sovereign bonds yielding less than 0%, government bonds performed well, particularly in Germany, Japan, and Switzerland. Leading the charge in non-US bonds may actually be a surprise to some, but repatriation demands and risk-off sentiment helped UK 10-Year GILTs pop nearly 5% (in pound terms) post the vote. Of course when adjusted for the massive decline in the pound vs. the dollar, US-based investors were better off elsewhere. Lastly, high-yield bonds continued the rally that began in Q1, finishing up approximately 5% for the quarter.
Many alternative investments struggled in Q2, with illiquid assets and managers focused on cyclical and higher quality equities lagging. Multi-strategy funds (represented by the HFRI FoF Diversified Index) rose only 0.2% for the quarter. Hedged equity managers (represented by the HFRX Equity Hedge Index) fell 1.0%, with growth-biased strategies underperforming value. REITs and Infrastructure performed well in a yield-starved environment, with global infrastructure stocks rallying another 8.6%, and global REITs topping 3.5%. Commodities led real assets, as energy and precious metals helped buoy returns.
- With Brexit firmly in the crosshairs we took a quick look at two of the biggest “exits” in US history. First there was the “Amexit” and the Revolutionary War, and then there was the South Carolina exit (i.e. secession), and subsequent Civil War. There are obviously no true parallels between exits that yield war and ones that do not. That being said, rate normalization tended to accompany not the beginning nor the end of the wars, but the announcement of new law/policy. The parallel to today is that the Brexit vote itself will only translate to normalization once the UK decides which withdrawal mechanism/policy to enact.
- The European Union is one of several arrangements that dictate inter-country dynamics across the pond. For context, the chart below shows just how convoluted the existing dynamic really is.
- Earlier in the commentary we touched on the fact that nearly a third of global sovereign debt currently carries a negative yield. Frustratingly, governments are not alone: almost 15% of European corporate debt currently carries a negative yield as well.
- We are sometimes asked about home country bias when allocating portfolios. Often lost in this conversation is the fact that within the US, regional biases are also quite pervasive in many US investor portfolios.
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