2016 Mid-Year Participant Letter WHAT BREXIT?

THE FIRST HALF OF 2016 provided a choppy ride. We were faced with continued concerns about global economic growth, uncertainty about interest rates, slowly rising oil prices and the prospect of a contentious U.S. presidential election. Stock market volatility spiked higher early in the year, fell off at the close of the first quarter and then increased again. At the end of the second quarter Dow Jones Industrial Average ended up at 4.31% as did S&P 500 at 3.84%.  The Barclays US Aggregate Bond Index also was positive coming in at 5.31%.  However, the MSCI EAFE (EAFE refers to Europe, Australasia, and Far East) ended down at -4.42%.

In the wake of the June 23 Brexit vote, stocks climbed for the second week in a row and reached near-record levels. At Friday’s close, as of 7/8/16, the S&P 500 was at 2,129.9, less than two points below its record set in May 2015, while the Dow was less than 1% shy of its record.

The 287,000 jobs that the U.S. economy added in June easily surpassed economists’ expectations for around 180,000. The surprise countered fears of an economic slowdown that arose after May’s jobs gain was far below expectations.

Risk aversion in the wake of the Brexit vote continued to fuel a price rally for bonds, and yields sank to multi-year lows. On Tuesday, the yield of the 10-year U.S. Treasury bond fell to 1.37%, the lowest on record and down from around 2.20% at the start of the year.

What if the initial market reaction was just a giant head fake? Such an out-of-consensus view can be made based on the lack of financial contagion, the benefits of Pound depreciation, procedural uncertainty and Austrian economics principles.

While the press is inclined to label Brexit a “Lehman” moment, no bank is shutting down as a result of the Leave vote. Thus, there is no immediate financial contagion parallel. While the market volatility caused pain for leveraged market participants, financial asset price contagion proved contained. Animal spirits are certainly impaired, but businesses will still operate and consumers will continue consuming.

Furthermore, the United Kingdom was already a fringe member of Europe that never fully adopted the European Union’s currency or monetary policy. The British Pound’s recent devaluation could even serve as somewhat of an economic stabilizer, which supports economic
growth as exports become more competitive and domestic goods become cheaper relative to foreign markets.

The process of getting from a Leave vote to actually withdrawing from the European Union is also very uncertain. While David Cameron has announced his resignation as prime minister, he will remain for the summer months, delaying his replacement’s ultimate activation of Article 50 to officially withdrawal from the European Union. An extremely adverse market reaction in coming months could result in the populace changing their minds, or it could lead to a renegotiation of the E.U. Treaty (unlikely given the poor precedent it would set, but possible). Even if the non-binding referendum does proceed, it will take an additional two years for the official process of leaving to be finalized. This prolonged time frame means that businesses will have ample time to gradually adjust strategies and adapt to altered future trading arrangements. Thus, this could end up being much ado about nothing.

Finally, from a bigger picture perspective, to the degree that extraordinary monetary policy measures globally have impaired free markets and needed reforms, maybe this is a global catalyst towards better fiscal responses in the future that rely less on the monetary policy of central banks to generate growth. If global central banks’ foray into negative rates and balance sheet expansion has only served to paper over structural growth problems rather than truly address them, then some short-term pain is needed to facilitate the longer-term gain that results from structural reforms and better fiscal policies.

Thus, while the initial Brexit reaction was pessimistic, a more constructive longer-term outcome is possible. Only time will tell.

If you have any questions about the financial markets or your portfolio, please do not hesitate to contact your independent financial advisor, Heffernan Retirement Services at 1-800-437-0045 or email Rebecca Tapia at rebeccat@heffgroup.com to set up an individual consultation today.

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