The second quarter of 2016 remained relatively quiet until June 24th when the citizens of the United Kingdom voted in a historic referendum to determine the country’s future within the European Union. The result: 52% of the population voted to leave while the remaining 48% voted to stay. The event, coined “Brexit”, sent shockwaves through the equity markets as the S&P 500® Index, the FTSE 100 and the ACWI ex-US fell -3.6%, -10.0% and -6.1% on June 24th respectively. Since then the markets have largely recovered in local terms, but does that indicate that the crisis has been averted? We will be the first to admit that we don’t know. It will take years for the United Kingdom to leave the European Union, and the truth is that the eventual outcome of Brexit is uncertain at best and unknowable at worst.
There are far too many connections between the United Kingdom and the European Union to discern how things may unfold. While it is natural to fear such uncertainty, we as investors must avoid succumbing to emotional decisions driven by fear. Naturally, it is turbulent times like these when we believe that a quantitative investment process rooted in a time-tested thesis, thoroughly examined across market and economic cycles, can help guide us into making prudent investment decisions. Emotion is often the enemy of long-term investment success, and correspondingly we divorce emotion from our investment decisions, which we believe will improve portfolio returns over time.
While we humans have no innate ability to predict the future, we believe examining some of the market’s major concerns is a useful exercise. Similar to other recent global panics, a major source of fear resides in the financial sector. The day after the vote, the MSCI Europe Financials Index fell -12.7% and was down -23.0% year-to-date at the end of the second quarter. This should come with little surprise considering London currently enjoys the number one spot on the Global Financial Centres Index. The Index is constructed through a combination of financial centre assessments and rankings of five instrumental factors: human capital, business environment, financial sector development, infrastructure, and reputational and general factors.
Source: 2016 Global Financial Centres Index 19, Published by the Z/Yen Group
It is difficult to foresee a situation where the United Kingdom exiting the European Union does not have a detrimental impact on the majority of the factors mentioned above. The resultant uncertainty puts further pressure on European Banks, many of which are still trying to recover from the 2008-09 Global Financial Crisis and the 2011 European Sovereign Debt Crisis. There will likely be tough choices ahead for many of these institutions as they navigate through more uncharted waters.
The United Kingdom’s largely domestic banks provide further insight into another of the market’s major concerns: the property market. Property prices in the United Kingdom have increased 20.4% in real terms over the past three years. In part, direct foreign investment from other countries in the European Union has driven these large price increases. If foreign direct investment begins to dry up it is a real possibility that housing prices could begin to head in the opposite direction. Investors have previously expressed concern over what seemed like unsustainable price increases and now Brexit has provided a catalyst for these investors to run for the exit.
The price movements of other property related assets supports this narrative. As of the end of the second quarter, the iShares UK Property UCITS ETF and the Bloomberg UK Homebuilder Index were down 14.91% and 32.34% respectively year-to-date. Adding to the panic, Standard Life Investments suspended trading in a £2.9 billion United Kingdom commercial real-estate fund as it was overwhelmed with redemption requests.
This brings us back to the most important question for U.S. based investors: how will this affect us? The primary risks at hand are that the United Kingdom’s exit could lead to the eventual breakup of the entire European Union, the entire United Kingdom, and/or that financial distress originating in Europe could spread through other developed economies. In an interconnected, global economy, these contagion risks are real but unlikely in anything short of extreme circumstances. A few market commentators have attempted to draw comparisons between this event and Bear Stearns closure of two hedge funds during the financial crisis in 2007. While it is too early to know for sure, we believe the fears of another global financial crisis unfolding are likely overdone. It is important to recognize these concerns but we caution against overreacting in light of the uncertainty. Remember, prior to Brexit the quarter was relatively calm. As a defensively oriented tactical manager, we believe our strategies can offer investors a certain peace of mind in uncertain markets. We will continue to monitor the situation vigilantly as it unfolds and make changes when our models deem them necessary. We thank you for your continued support and confidence in BCM.
Beaumont Capital Management [email protected] (844) 401-7699
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