On June 23, in what will go down as a historic day in global politics, British citizens voted to end their 43-year relationship with the European Union. Depending on your present company, this change comes as either a shock or a foregone conclusion. But regardless of predictability, the fact is that, we have to address the obstacles that this decision presents to us as investors. Global markets began tumbling as soon as the news broke, and now the speculation begins as to what happens next. Uncertainty is driving this process, and uncertainty is one of the biggest drivers of fear. That doesn’t mean we have to be subject to questionable decision making in a time of crisis. Taking a deep breath in and a giant step back, let’s answer what questions we can and create a plan.
What happens to the U.K. after the “exit” vote?
- The negotiations of Britain’s exit will take place over two years, during which, economic growth is expected to be slow. Businesses will be less likely to make investments as they await the longer term effects of leaving the EU.
- Trading agreements will need to be renegotiated. The terms of which are completely up for speculation as to whether they will benefit or stifle the British economy.
- Scotland and Northern Ireland may reconsider breaking away as their political leanings tend to be more in line with the EU.
- The pound had already depreciated leading up to the referendum and continued to plummet following the decision.
Why are markets outside of the EU reacting so much?
- The market effects of Brexit are not isolated to the EU markets. The impact of this decision is uncertainty for Britain, for the EU, and for all economies touching these regions.
- The currency effects are driving swings in the commodities markets, which in turn has an impact on all of those economies dependent on them.
What sectors will be hardest hit?
- When it comes to Brexit, not all British companies are created equal. Multinational banks will likely be hardest hit, while regional banks will experience less real economic impact. Multinational companies in general, however, will be at an advantage due to the depreciating pound. Think back to late 2015 when a lot of multinational U.S. companies experienced lower earnings due to the appreciation of the U.S. dollar.
- Credit ratings for U.K. government bonds may sink following the vote. Uncertainty again is the name of the game, and after considering the risk-adjusted returns, this is not an attractive sector.
How should we position our portfolios?
- During times of high volatility, asset classes tend to increase in correlation, which unfortunately decreases the benefits of diversification. It is important to remember that in this scenario, “decrease” is not synonymous with “eliminate.” The use of co-varying asset classes where possible will be increasingly relevant through the second half of this year.
- Within the international equity allocation, it is next to impossible to time a “correct” political outcome. Making these kinds of investment decisions is very risky. We can look to recent history in Brazil to inform us. Brazilian equities skyrocketed 27.7 percent in Q1 20161 after positive developments in political leadership. It would have been great to be invested in this market, but if you consider that earlier in the year all economic indicators pointed to continued weakness, it would not have appeared to be a wise move. The events that led up to the crackdown in corruption were unpredictable and provided only a tenuous respite from lagging performance.
- Within our international equity allocation, we have maintained exposure to developed international equities and deployed active managers that individually reacted differently to an “out” or “in” vote. Together, the goal is to smooth the ride down or up as the markets work through this event.
- Within our overall portfolio, we had increased our allocation to co-varying asset classes at the beginning of the year to combat market volatility that we expected to flourish throughout the year from all sources.
What is the next step?
- This is a fluid situation and we will continue to update our market outlook and investment strategies as we learn more.
- Consider investing money on the sidelines. Every year it seems there is a major event that sets the markets into a downward spiral. In a long-term strategy, we view those times as pockets of opportunity to invest new money while the market is low.
- Talk to your financial advisor. You will no doubt receive a lot of information in the coming weeks about what to do, and you should discuss these concerns with your trusted advisor before making any big decisions.
1 Morningstar data
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
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