KFM Newsletter: A Look at Brexit

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Earlier in the year, my wife and I planned a trip to London with a goal to see Stevie Wonder at Hyde Park on July 11thfor our 29th wedding anniversary. We had asked our kids if they would like to go, but they all said “no” for a variety of reasons. When it came time to commit to the trip, the kids changed their minds and decided it wasn’t “fair” that we were not having a traditional family vacation. So Diane and I booked a family vacation to the Big Island of Hawaii with the children instead.

In so doing, we lost out on a 25% discount by not going to London. For starters, air fares have dropped substantially due to more seats being available. The strength of the U.S. dollar along with the drop in the British Pound would have decreased our lodging and meals by 25%.  Even the concert tickets dropped by over $200 per ticket. Had we known “Brexit” was going to pass, not only would we have gone, but we would also have taken our children along regardless of their lack of “enthusiasm” for going to London. Instead, we hit the Big Island of Hawaii during peak season, paying premiums on everything that we would like to do while we enjoy our time together.

So, what just happened?

The announcement early Friday morning that British voters chose to exit the 28-nation European Union by a 52% to 48% margin defied appeals from every major European economic and political institution. The surprise vote to “Leave” was part of a move to sovereignty and a rising rebellion against the political establishment due to slow growth, income inequality and disagreements on immigration reform (similar to the U.S.). U.K. Prime Minister David Cameron stated that he will resign by October, since he staked his reputation on a “Remain” vote. The response to the vote was market chaos as risk assets immediately plunged -- global equities lost roughly -4.8% or $2 trillion in market value (according to S&P), the British pound fell to its lowest level since 1985 and the euro and oil all dropped significantly last Friday June 25th. While this occurred in the global equity markets, traditional safe havens, notably U.S. government bonds, gold, the U.S. dollar, Swiss franc and Japanese yen, rallied in a “flight to safety”. The outcome was an unforecastable shock (the U.K. betting markets had put a 79% probability on a Remain vote even though recent polls suggested a close vote) and surprised the markets.

We do not consider the so-called Brexit to be a cataclysmic event like the “Lehman moment” in 2008. In contrast, the Lehman Brothers’ collapse in September 2008 led to a serious global financial crisis because of the precarious interrelated position of the banking system. Today, U.S. and European commercial banks have substantially more capital and considerably less leverage and central banks are currently poised to help stabilize markets unlike 2008.

With this most recent event, the Fed is unlikely to raise rates later this year unless global financial conditions stabilize and employment improves. The Bank of England moved swiftly and announced it was ready to provide $460bn in liquidity and it is expected to soon cut rates and the Bank of Japan will probably further ease policy in July.

The U.K. exit process will be long, complex and difficult over at least a two-year period. Prolonged uncertainty in the EU (potentially including more “exits”), political turmoil in the U.K. and declines in trade, foreign investment and immigration will slow growth, or trigger a recession in the U.K. and retard growth in the rest of European economies over the next year or two. Since the U.K. is less than 4% of the world economy most economists expect the U.K. decision to slow GDP growth in the rest of the world by a relatively modest 0.2% over the next 12 months.

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It will be some time before all the outcomes of this historic change become evident. There is even the possibility of a second referendum on both the U.K. leaving the EU and Scotland leaving the U.K. (a majority of voters in Scotland and Northern Ireland voted to remain in the EU), and millions of U.K. voters have signed an online petition demanding a re-vote of the referendum.

Despite Friday’s turmoil in global financial markets and the likelihood of aftershocks in the market, we believe that the U.S. will experience continued moderate economic growth, coupled with low inflation and low interest rates. As always, all investors should avoid knee-jerk reactions and decisions, be prepared for a period of relatively indiscriminate selling and market volatility over the next few weeks and dispassionately look past the near term turmoil. We believe it is important to maintain target asset allocations while rebalancing to take advantage of the price movements when appropriate. Changing long-term asset allocations and investment strategies on the basis of emotional reactions to frantic short term panics will only do more harm than good.

For years, we have always joked about closing our offices from Memorial Day to Labor Day as our clients participate in graduation celebrations, family reunions and travel. We know our update meetings generally slow down during the summer months for these reasons. But the past three summers have included concerns over Portugal, Italy, Greece and Spain (2014), China (2015) and now Great Britain with “Brexit”. Just like we saw fairly quick recoveries in 2014 and 2015 from the “panic” reaction created by each of the summer events, we fully anticipate the same with “Brexit”.  For any of you that are thinking about traveling abroad, now might be a great opportunity to take advantage of the strength of the dollar. Don’t miss out on the unique once in a life time drop in prices like Diane and I did. If only we had the proverbial crystal ball to predict the significant discounts, it would have been a done deal.

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As for statement values, fortunately the markets bounced back a bit in the last few days of the June. It appears this may only have been a very short-term (two days) “shock” to the capital markets. Had the quarter ended mid-June, you would have seen fairly decent valuations coming from the asset classes included in your portfolio. Regardless, we do not see this as a cataclysmic event or detrimental to the long-term outlook of your financial well-being. We hope all of you had a safe and happy Independence Day! Please continue to enjoy the remainder of your summer appreciating and enjoying what matters most!