During almost all of the second quarter, U.S. equity markets seemed impervious to bad news. Through June 23, the S&P 500 traded in a 100 point range between 2,025 and 2,125, close to its record high of 2,134 in May, 2015. Then came Brexit.
Pundits, experts and polls did not expect the U.K. to vote to leave the European Union. Usually, people vote in their economic best interest. Money managers believed this, and their surprise contributed to the violent sell-off in equity markets in the days that followed.
We, too, believed Britain would vote to remain in the European Union; but given significant structural issues facing the entire Continent, our exposure to Europe was and remains low. Only 1% of our equity holdings are domiciled in the U.K. and less than 9% in Continental Europe. Over 40% of the European equities we own are based in Switzerland which never joined the E.U. The remainder are dominated by industrials and energy exporters who generate the majority of their sales outside the region. Europe represents only 15% of sales for our combined portfolio holdings. We believe the source of global revenues is as relevant a long term investment criterion as country of domicile.
An Imperfect Union
Since the formation of the European Union in 1993 and the introduction of the Euro currency in 1999, many experts questioned their sustainability. Doubts stem primarily from a union having monetary authority but no fiscal authority.
Over the years, there have been occasions when it appeared that a member nation might secede, with the Greek bailout referendum being the most recent. However, before now, no member has left. Brexit represents a significant break from the post WWII movement toward open trade and economic integration across Europe. In many respects, it is fortunate that the first country to separate from the Union was not a member of the Euro currency. Secession by a member of the currency union would be infinitely more complicated and likely have far greater financial consequences.
Global Implications of Brexit
The U.K. economy represents less than 3% of global GDP, so in and of itself, a recession in the U.K. should not materially slow global growth. However, in the short-term, the Brexit decision will increase volatility in financial markets and fuel demand for “safe-haven” assets like the U.S. dollar. A stronger dollar effectively tightens financial conditions in the U.S. and the 40% of the world economies that tie their currency to the dollar. This will likely cause a temporary slowdown in global growth.
Longer-term, if the separation is orderly and other European countries do not follow suit, we think this will be unfortunate for Britain, but will not have broader impacts. On the margin, it may turn out to be beneficial for Luxembourg and other money centers in Continental Europe that could see increased investment as financial activities are redirected from London to secondary European money centers.
An Investment Perspective
The Brexit vote and other nationalistic/protectionist movements are essentially responses to non-economic problems. From an investment perspective, protectionism has the potential to diminish one of the few economic bright spots of late. Globalization has improved productivity, increased corporate profit margins and lowered prices for most consumer products. This potential negative combined with the surprise factor of the vote outcome had the markets looking shaky before firming up quickly. Events in Europe are still unfolding. Other crises, related and unrelated to Brexit, are sure to follow. When, where and what are unknowable. What we do know is that there are still attractive long term investment opportunities in the global equity markets. We believe our thematic investments can ride the tailwinds of strong secular trends. Companies at the forefront of innovations in robotics, genomics, urbanization and data inundation will, we believe, outlast the next crisis and outperform the markets over time.
We also see near-term opportunities in certain markets, sectors and companies that are out of favor or undervalued. Currently, only 1% of our holdings are in Japan but the risk/reward trade-offs of some segments of the Japanese market look attractive. Similarly, European banks look extremely undervalued with many of the uncertainties priced in. On balance, we think it presents a buying opportunity, particularly with respect to banks with Eurozone exposure as opposed to U.K. domestic earners. Many are trading at less than 50% of book value with
high single digit yields.
From a fixed income perspective, the most important and immediate implication of the U.K. decision to leave the E.U. is lower sovereign yields. The uncertainty created by this event triggered a flight to safety, sending sovereign yields lower in all major bond markets including the U.S., Japan, Germany, France and the U.K. Not surprisingly, U.K. yields fell the most.
The 10-year U.S. Treasury bond fell to 1.40% the day after the Brexit result. On July 1st it declined below the former all-time low of 1.39% in 2012. Prior to the vote, the 10-year had been trading in a range of 1.70% to 1.95%. It started 2016 with a yield of 2.27%. Market reactions to unusual events tend to have similarities. Looking back at past financial crises, immediately after the 1987 stock market crash, 1998 failure of Long Term Capital Management and 2008 Lehman bankruptcy, yields fell briefly and then evened out. We think the 10-year U.S. Treasury bond will rebound from these extreme levels and trade in the 1.50% to 1.70% range until there is a clearer picture of the implications of the U.K. vote and the impact on U.S. and global economic growth.
A current consensus view in both fixed income and equity markets is that inflation will remain at extremely low levels. As a result, buying inflation protection in the form of Treasury Inflation-Protected Securities (TIPS) is relatively inexpensive. Core CPI, which excludes food and energy, has been above 2% per year for the past seven months. We think it is highly likely that once energy prices stabilize due to supply reductions which are already underway, aggregate CPI will rise to this level, or higher. In addition to TIPS, we continue to purchase both taxable and tax-exempt investment grade bonds with average durations between three and four years. Given recent flattening of the yield curve, we believe these bonds offer value with very modest risk.