Update after Brexit
We can’t remember a time when a vote in a foreign country has received as much attention domestically as the one in the UK to leave the EU. Its amazing that a single political referendum, intended to unite the British Conservative party, could create so much angst around the world. Of course, just about every financial media personality has now become an expert on British-Euro politics and economics. We will try to spare you too much additional pontification on a subject that concerned very few of us until last week. Its not that we don’t think this is an important event, quite the contrary. Its just the airwaves, twitter streams and talking heads have given us nonstop instant analysis over the past few days. We are probably better suited to listen and reflect for a while before adding to the cacophony of opinions being offered.
In broad strokes here are some of the main issues that have emerged thus far. These aren’t intended to be opinions, just some of the themes we have assimilated.
- Financial markets around the world reacted negatively to the news and a flight to safety ensued. Stocks & commodities sold off and the British Pound took a pounding. Sovereign Bond yields are setting new record lows throughout the developed world, including Britain even after the credit ratings downgraded their debt. Precious metals and defensive sectors such as Utilities have continued to do well as they have for most of 2016.
- Now that the UK has voted to leave the EU, the actual mechanics and timing of implementation have to be worked out. Its anything but clear today on what the actual plan to leave looks like. The EU, in an attempt to dissuade others from attempting the same maneuver, is not posturing to make this an easy and smooth transition for the UK. The talking heads and other experts have different opinions about the details but most think this will be a messy affair to sort out.
- Political commentators are drawing parallels between the Brexit vote and the Presidential race in the US. It seems to many of them that anti-establishment sentiment is now a well established global phenomenon. Some are even admitting that this global movement against the status quo has been underestimated, misunderstood and in many cases dismissed simply as ignorant bigotry. Its now more clear that the issues are more complex and cut across demographics and political ideology in new and surprising ways. Was this the opening salvo in a coming storm of successful anti-establishment politicians and parties? As of today it doesn’t look like the UK will be the last country who will have a serious conversation about leaving the EU.
- The consensus opinion is that this will be a disaster for the UK. In the short-run, it looks like financial markets might be the primary mechanism for delivering pain. In the long-run, the outlook (and we will pontificate for a second here) its less clear. See next point.
- Some are speculating that Britain is just the first domino to tip in the failure of the EU experiment. We have worried about the sustainability of the union since the Greek crisis in 2012. If the EU is a sinking ship is it better to be the first one off (deal with the pain now) or go down with the ship? Only time will tell how this all shakes out for the UK and the European Union as well. We don’t know what will happen but we sense a growing fear (desperation) among the political and economic ruling class in Europe threatened by a disintegration of their experiment with globalization.
- The European banking sector has struggled all year and has gotten walloped further this past week. Experts are watching the banking sectors in countries like Italy to see if this is going to have a ripple-contagion effect on the European financial system.
- Lastly, US interest rates have fallen back to near record lows. The TED spread (the difference between 10 year and 2 year treasuries) has fallen to an all time recovery low. This is usually not a good sign for economic growth. The markets have shifted from an expectation of the Federal Reserve raising interest rates again this year to a small likelihood they might actually lower them this Fall. The Fed started backpedaling their plan to raise interest rates even before this vote. Where does this put them now?
We were watching the UK referendum polling the past couple of months, but in our attempt to know what we don’t know we made no predictions on what the outcome would be. There are just too many opinions and scenarios to digest, so we have tried to focus on how we can continue to position portfolios this year for a variety of outcomes and macro trends we are watching play out over the next couple of years.
For most of 2016 our portfolios have been positioned “uncomfortably conservative.” As we have written about previously we have reached the highest cash position ever in our equity portfolios in hopes of deploying it at more attractive valuations later. The S&P 500 is up a bit for the year (as of this writing) and we still aren’t real excited about deploying new capital here, even after the sell-off following the Brexit.
We have continued shortening our bond durations thinking sooner or later interest rates will go up. While we may have gotten less bang for our buck had we owned longer duration bonds recently, most clients have still benefited from their short duration bond exposure this year. Its amazing how much sovereign debt around the world is trading at negative yields, truly a new phenomenon unlike we have ever seen before.
In terms of equities, we have been overweight defensive sectors all year and so far that has proven to be a good spot – Utility stocks (as of this writing) even responded positively to the Brexit – or more accurately the corollary effect of lower interest rates. We have maintained exposure to precious metals for the past 2 years. Last year those positions hurt performance but this year they have been by far the best performing holdings in our portfolios. They seem to do well when markets question the effectiveness, or perhaps, sanity of central banks. We see them as a portfolio buffer when fear is high and policy mis-cues are rampant.
We do manage a portfolio with global equity exposure, a position we think needs to grow in the long run, especially as it pertains to emerging markets. Today, we have some exposure to Europe, the UK as well as emerging market equities. Most of our foreign exposure is through ETFs, but we also have some individual holdings of companies domiciled in the UK and Europe. We are monitoring those as we do all holdings but feel comfortable right now with our level of exposure and still like the prospects of our individual holdings in those areas.
We haven’t found it helpful to get overly caught up in the drama of surprising, or unsurprising, geopolitical events. In these situations gut instinct is usually the wrong instinct. Instead of trying to predict the future and then make investment decisions, we have become more and more of the belief that the markets themselves are probably the best predictor of the future. We are trying to ask questions about what the market is telling us that we can’t see through the barrage of data and opinions.
Our models are telling us that not much has changed. If we had to guess though, we might get even more defensive before we get aggressive again.
If you have any questions about our strategy or anything else, please give us a call or shoot us an email.