You may or may not have been thoroughly paying attention to the Brexit issue (Britain's Exit, or “Brexit”, from the European Union), but it will certainly be forefront in the news today and likely for a while.
To quickly catch up those of you who have not been following this news, there was a referendum held in England yesterday whereby voters were to decide if the country should remain in the European Union or exit it. The two primary arguments for the Exit camp were: 1) EU regulation is driven out of Brussels, the EU capital, for which there is no British voter representation and 2) immigration decisions are being driven by the EU that the British don’t necessarily approve of. Ironically, when thinking about the first point, you could say that the British were protesting taxation without representation!
The “Remain” (or “Bremain” camp, as it’s been labeled) group argued that departure from the EU would hurt Britain economically by placing new obstacles in the way of free trade and the flow of goods and services that the EU facilitated. Additional countries may also try to leave the EU, further damaging the second largest economic entity in the world. If you recall, Greek financial issues a couple years ago caused fears of a “Grexit”, which has not happened yet. Unlike Greece, Britain is the second largest economy in the EU (behind Germany), and is the 5th largest in the world. London remains one of the world’s largest financial centers. Economically, investors worry that there will be new barriers to free trade at a time when the world economy is already struggling to maintain even low levels of growth. Politically, it also leads to increased volatility and unknowns. As of this morning, Prime Minister David Cameron said he would step down so that new leadership could guide the UK forward after the vote. The Prime Minister lobbied hard for Bremain, but lost the referendum.
Today, the markets are reacting quite negatively. The British Pound is currently down about 8% against the dollar. European stock markets are currently down between 3-8% while Asian stock markets are down between 1-8%, with Japan being the worst hit at roughly 8%. The US market just opened and the S&P 500 is down roughly 2.5%. Conversely, as is to be expected during times of market turmoil, Treasury bonds and gold are performing well. The 10-year U.S. Treasury Bond yield is down to 1.565% (perhaps good opportunities to refinance your mortgage are coming) and gold is up 4.50%. The worst hit commodities, surprisingly, are coffee and cocoa.
The markets are also getting a lesson in humility, as the polls consistently showed the race to be a dead-heat, but the markets had priced in a roughly 80% chance that the Bremain camp would prevail. As such, markets have been generally positive for the last week as confidence for a Bremain vote grew. Part of today’s reaction is an unwinding of overly confident investment positions taken by some investors who didn’t get the outcome they expected.
While markets are, and perhaps will remain, volatile because of the political and economic uncertainty, this is likely to be temporary. Britain was not a fully-immersed EU country in the first place. It maintained its own currency and was exempt from certain EU rules. Nonetheless, disruptions like this at this time are particularly unsettling for those fearing slow growth in the world economy. In the short term, you can expect volatility to continue, but in the long run I am confident a new equilibrium will be found. With this type of price decline, it’s a good time to think about buying as others sell in panic over temporary issues. Not all companies are tied to global trade and even those that are will try to quickly find the most advantageous path in the economic reality.
As for what to do now, I will be looking for opportunities to rebalance portfolios when and where needed. With a decline in interest rates, you may want to consider refinancing your mortgage or other actions that capitalize on low rates. It is also unlikely that the Federal Reserve will raise rates for the remainder of this year. Where clients have bonds in portfolios, I tend to use a higher proportion of U.S. Treasury bonds in portfolios for exactly these occasions. While there is no way to completely avoid movement in the stock market, diversification and U.S. Treasury bonds, which have a low or negative correlation to the stock market, provide the best buffer, liquidity and counterbalance to stock market volatility.