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Brexit Commentary

By Kenneth J. Entenmann, Chief Investment Officer

NBT Wealth Management

July 14, 2016 – Three weeks after the surprising vote by the United Kingdom to exit the European Union, the projections of doom, catastrophe, disaster, calamity and collapse have failed to develop.  Political and financial pundits around the world predicted a “worldwide crisis.” Well then, this is the weakest (and perhaps shortest) worldwide crisis ever! It seems William Shakespeare was right; all of the fear mongering of Brexit was “…a tale told by an idiot, full of sound and fury, signifying nothing.” In fact, just three weeks later, the S&P 500 has reached its all-time high.

Brexit is the announcement of an ugly divorce. Now the hard part begins…the negotiations will start (who gets the house … the kids … the antique table?) and talk of “UNCERTAINTY” will dominate the media waves. We have already seen dramatic changes on the UK political front. Fortunately, this will take many years to work out. The over the top propaganda catastrophe, disaster, economic collapse and even World War III from both sides will subside and a more sober debate will follow.

To be clear, this is a significant political and financial event that will have consequences, particularly and obviously in the U.K. and Europe, but also in certain economic sectors like finance and trade. Market political history suggests the reaction would be swift (it was!) but not long lasting (it wasn’t!). Historically, a 10% correction in the equity markets has been common but the markets failed to decline that much. Indeed, the initial market reaction was extremely hyperbolic and negative. A significant “Flight to Quality” or “Risk-Off” trade occurred and will likely persist in the near-term: U.S. dollar strength, significant inflows and therefore lower yields on U.S. Treasury bonds, sharply lower worldwide stock markets and high volatility in stocks.

Yet, all of the “sound and fury” has whimpered out. Here are some general thoughts on Brexit:

  • Equity Market Performance: After quick and sharp declines, world stock markets have recovered nicely. U.S. equity markets are all up sharply since the Brexit vote. More importantly, most of the major world equity indices are positive over the last three weeks:

Index as of 7/8/2016

Since Brexit

3 Week

S&P 500 TR USD

0.89

2.95

Russell Mid Cap TR USD

0.45

2.83

Russell 2000 TR USD

0.54

2.98

MSCI EAFE NR USD

(5.56)

(0.10)

    FTSE 100 TR GBP

4.03

9.55

    FSE DAX TR EUR

(6.12)

(0.02)

MSCI EM NR USD

(0.42)

3.34

DJ Global World Real Estate TR USD

1.28

3.59

Bloomberg Commodity TR USD

(2.19)

(2.60)

Barclays US Agg Bond TR USD

1.93

1.56

Citi WGBI NonUSD USD

1.46

1.68

Barclays US Corporate High Yield TR USD

1.01

2.11

  • Market Volatility: The VIX index measures the market’s forecast for volatility and is widely known as the “fear” index. Indeed, the day after Brexit, the VIX index jumped from 13 to 26, a significant increase. Yet, one week later, it settled back to 15 and has remained at that level. Higher than a few weeks ago, but hardly forecasting “catastrophe.” To put this into perspective, during the 2008 Lehman Brothers failure, the VIX exploded to a level of 86! Now that is a crisis! Other market measures of “fear,” such as credit default swaps and credit spreads in the high yield markets, have acted similarly. A big spike that petered out quickly. There is little indication that Brexit is causing wide spread fear in the markets.
  • Interest Rates: Brexit likely eliminates a Fed rate hike any time before September as they have a ready-made excuse of “uncertainty” to delay. Indeed, calls for a rate cut are already out there! The bellwether 10-year Treasury note has seen its yield drop from 1.85% on June 1 to 1.49% on July 12.. And while a 1.49% yield seems paltry by historic U.S. standards, it is downright “juicy” compared to other sovereign debt instruments! Today, over $11 trillion in sovereign debt trades at negative interest rates! This higher relative yield will keep a bid for U.S Treasury bonds and that means interest rates are likely to remain “lower for longer.”
  • Trial and Punishment: There is a notion that the EU will “punish” the U.K. in the exit negotiations to send a powerful message to other EU members that might consider heading for the exit like the U.K. There is, however, one very important distinction between the U.K. and other EU members. The U.K. maintained its own currency, the British Pound, while all of the other members converted over to the Euro. Brexit will be a long and arduous process. Any other EU member exit would also involve the re-establishment of a single currency, making an already challenging exit significantly more difficult. So, the likelihood of a rush of EU members to the exits is grossly overstated.
       Another claim is that the EU will lock out the powerful London financial center banks from EU business. While possible, and certainly some financial jobs will migrate to the continent, a general lock out is doubtful. The general state of the continental European banks is poor, as demonstrated by the recent concerns about Italian banks. If the EU were to lock out London, one would have to question where the continent would find its financing!

After all of the sound and fury has diminished, the general consensus on Brexit has been modified to “bad for the U.K., bad for the EU and a modest negative for the rest of the world.” That is a far cry from the projected doom of just a few weeks ago. By all means, Brexit will cause economic dislocations. For example, the EU equivalent of our Food and Drug Administration resides in London. Clearly, if Brexit comes to fruition, these jobs will relocate to some other European city. Bad for the U.K., but good for the new city!

Also, the UK economy, like most of the EU, is far more dependent on exports than the U.S. Exports represent roughly 13% of U.S. GDP; exports are 30% of U.K. GDP. One of the lasting results of the last week is that the British Pound has lost nearly 11% of its value relative to the U.S. Dollar. Bad for the overall U.K.? Perhaps. But a big win for the exporting companies that dominate the FTSE stock index! Not every consequence is bad! Indeed, over the last three weeks the FTSE 100, the major U.K. stock index, is up nearly 10%!

At NBT Wealth Management, our investment philosophy is based on two fundamental principles that have endured the test of time. One is that market timing—even in a “worldwide crisis”—is a fool’s game that is rarely won. The other is that broad diversification across multiple asset classes over long periods of time provide the best opportunity for financial success.

In other words, ignore the tales, full of sound and fury, told by idiots. That is the lesson that the last few weeks following the Brexit “crisis” has demonstrated. Lots of sound and fury, signifying nothing!

The views expressed here are those of Ken Entenmann and should not be construed as investment advice. These views are subject to change. All economic and performance information is historical and not indicative of future results.

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