The United Kingdom’s vote to leave the European Union, or EU, and Prime Minister David Cameron’s inevitable exit creates a lot of uncertainty. Nobody knows what will happen or when, which often prompts the markets to retreat to perceived safety. The fog of confusion will most likely persist: The terms of exit will be negotiated among the EU’s 27 members, each of which will have a veto. European legislation provides a period of up to two years for the “divorce” to get settled.
How will this affect the investment markets and your portfolio? In general, as long-term, value investors, we aren’t moved by these market disruptions, which usually are temporary. Instead we view these situations as a chance to buy assets we like at lower prices.
The impact
- A Brexit would likely mean the U.K. would lose the passport rights for the financial industry, a mainstay of the British economy. This would make it harder for U.K. financial companies to do business in Europe. Most likely, treaties will be negotiated to keep business running as usual, but we don’t know on what terms as it will most likely depend on the political climate.
- Trade agreements will have to be negotiated anew, not just with the EU, but with other parties with whom the E.U. has trade deals. There are alternatives, but generally speaking, there is a politics-economics trade-off: The less these agreements bind the U.K., the less beneficial they will be from a free-trade standpoint.
- The Brexit might redraw political boundaries as well, both in the U.K. and in the EU. Scotland and Northern Ireland are firm supporters of EU membership—as reflected in their vote yesterday. Both have also questioned, at different points in time, whether they should remain in the U.K. – meaning that the Brexit may give a second wind to secessionists.
- For the EU, Britain’s vote proves that European membership is reversible. The situation here then becomes that other countries might head for the exit as well. Euroscepticism is particularly high, according to polls, in Greece and France. Leaving Europe, however, would be a lot harder for countries that have adopted the euro than for the U.K. Even if no other countries leave, the Brexit might slow down the process of EU integration.
Markets implications
The news of the Brexit vote hit currency markets the hardest. The British pound fell 8.3% against the U.S. dollar Friday morning to its lowest level since the mid-1980s. Meanwhile, the U.S. dollar appreciated against most major currencies, reducing the value of international assets to U.S. investors. European financials stocks sold off more than 10% as increased regulatory uncertainty of the European financial system weighed on share prices. In the U.S., the S&P 500 dipped 2.8%, while the 10-year U.S. treasury yield dropped sharply to 1.55%, reaching its lowest level since 2012. Source: Bloomberg
Portfolio implications
Major selloffs often spur a variety of responses by investors. Initially, many become consumed by media accounts of the specific causes, with the negative implications reinforced by the losses in the market. Often that leads to a fear-based response to sell after markets are down in an attempt to avoid future losses. This typically only locks in the current loss and prevents the investor from benefitting from future market gains.
At Morningstar Investment Management LLC, we make every effort to resist emotional responses and focus on our efforts to find assets that are inexpensive relative to their intrinsic values. We find that the best opportunities for future gains often come when markets overreact to news and forget that in the long term, prices reflect the future cash flows a security generates. With equities, stock prices should move based on changes in the long-term earnings power of the company.
In that spirit, we think that the selloff driven by the Brexit vote has the potential to create opportunities for our portfolios in cases where prices have moved away from underlying value. We see less opportunity in long-term government bonds that rallied on weakness in stock markets and we’re evaluating the hardest hit parts of the market looking for areas that have been unfairly beaten down.
