When the Dust Settles: The World after Brexit and What it Means for U.S. Investors

Monday, August 15th, 2016
By Charles McNally, Chief Portfolio Analyst, Manifold Fund Advisors

After the United Kingdom’s unexpected referendum result supporting a departure from the European Union, both mainstream and financial media had no shortage of reactions and opinions on the topic. The next unexpected development was how quickly financial markets adjusted to the news, faster than many opinionators could reach a television studio.

What follows is a short appraisal of the potential impacts for investors in the months ahead. If you are interested in further commentary from our Portfolio Managers or Investment Professionals, please contact our Advisor Support Team at (844) 747-5292 or email us at info@americanindependence.com.

The Politics of Policy

The political aspects of the United Kingdom (UK) departing the European Union (EU) are certainly intriguing – and potentially precedent-setting. With two years to negotiate an exit from the bloc, beginning when the new Prime Minister, Theresa May, invokes Article 50 of the Lisbon treaty, headlines may include posturing, backpedaling, and political theater.

Through this all, it seems clear the EU will seek to impose significant costs on the UK (to ensure that other member states are disincentivized from seeking their own exit). Nevertheless, it also appears that Great Britain will remain an important European trade partner, potentially with a trade relationship similar to that between Norway and the EU.
Since the last recession troughed in June 2009, the global economy has neither generated escape velocity nor fallen into negative territory despite massive monetary intervention and a series of extraordinary negative events. Will this event be different?

What does this all mean for financial markets and investors?

While the markets did a near-term adjustment to the initial Brexit news on Friday, June 24th, and the press continues to discuss a negotiated withdrawal that can take up to two years, the information horizon that matters to investors now stretches into early 2017. That is when economic statistics will start to become available that indicate whether the Brexit impact on global Gross Domestic Product (GDP), which should detract somewhat from third quarter growth, carries over into the fourth quarter and beyond.

In other words, the markets are currently guessing whether or not this event has “legs” to tip the global economy into recession. Since the last recession troughed in June 2009, the global economy has neither generated escape velocity nor fallen into negative territory despite massive monetary intervention and a series of extraordinary negative events. Will this event be different?

Will Brexit affect Central Banks?

First, accommodative Central Bank policy continues throughout the world and near-zero interest rates can mitigate the effects of events such as Brexit. In the case of the UK, Bank of England (BOE) Governor, Mark Carney, immediately indicated that “the economic outlook has deteriorated and some monetary policy easing will likely be required over the summer”1 and authorized a 250 Billion Pound liquidity facility that the BOE has at its disposal.

Although the BOE’s Monetary Policy Committee (MPC) voted to maintain Bank Rate at 0.5% and the size of the Asset Purchase Programme at 375 Billion Pounds at their meeting on July 14th,2 they followed with stronger easing measures at their next meeting on August 4th. This included cutting the Bank Rate to 0.25%, reviving a program to purchase UK government bonds, extending that program to include corporate debt, and creating a new term-funding program for banks lending to households as well as businesses.3

For the United States, the potential for Brexit to impact global growth may already have delayed a possible interest rate hike from the Federal Reserve, and it may decrease the likelihood of successive rate increases in the months ahead.

What impact will U.S. investors feel?

The combination of a dramatically lower Pound and heightened uncertainty for companies doing business in the UK create a threat of British economic slowdown over the next 1-2 years.

The magnitude of the slowing influence is difficult to assess, due to the fact that a withdrawal from the EU is unprecedented and nobody knows exactly what the British Parliament will do with the nonbinding referendum’s result — or how their negotiations with the EU will turn out. Of the 55 forecasts currently on Bloomberg’s economist survey (all updated since the referendum), only 8 predict negative real GDP growth for the UK in 2017.4
“Until evidence of Brexit’s impact emerges, economic forecasts for areas outside the UK are likely to incorporate only minimal adjustments, if any. So the impact is likely to be felt in earnings reports before economic forecasts.”

The S&P 500 Index has limited exposure to the UK (roughly 4%) and 17% exposure to continental Europe. With that in mind, the primary Brexit threat for U.S. investors doesn’t come from direct exposure to the UK economy, despite the fact that most multinational companies derive some revenue from Britain, which collectively should decline with a UK slowdown.

The drop in the Pound grabbed headlines, but Dollar strength was the other side of the currency markets’ reaction: flight-to-safety cross-border capital flows kept the U.S. Dollar firm in the face of fading expectations of Federal Reserve tightening. A strong Dollar negatively impacts U.S. multinational corporations, both by reducing the dollar value of revenues earned overseas and by making the prices of their goods and services uncompetitive in the global marketplace. Although the Dollar’s strength has eased recently, the Pound has not recovered, and the threat of a Dollar jump hangs over U.S. export-oriented sectors during periods of market instability.

A “wait and see” response to the uncertainty already present in an extraordinary Presidential election year could prompt further hesitation by businesses making multi-year hiring and capital expenditure plans. The latter point affects large companies globally, raising the risk of a global slowdown that would tip the slower-growth economies into recession.

When “waiting” stops, what might markets “see”?

Until evidence of Brexit’s impact emerges, economic forecasts for areas outside the UK are likely to incorporate only minimal adjustments, if any. So the impact is likely to be felt in earnings reports before economic forecasts.

In the two weeks following the vote, 15 companies in the S&P 500 included a discussion of its possible impact in investor communications, ranging from minor to negligible.5 Just to compound the confusion, any immediate impact reflected in third quarter reports may be dismissed as transitory phenomena, causing markets to wait for confirmation from fourth quarter earnings and economic statistics.

Safe haven assets such as developed market sovereign debt have already traded to record low yields that would be consistent with recession, except for the fact that government deficits are declining and central bank bond purchase programs are reducing supplies of government bonds. However, the spectrum of non-sovereign debt stands to stratify along quality lines if recessions appear imminent, with the bonds of companies with unimpeachable credit in great demand and all other debt falling out of favor.
“Active management has the potential to add value in an environment where earnings are likely to be impacted by the U.S. dollar amidst increased headline risk, and with an uncertain outlook for global growth.”

Equities and most industrial commodities could also be at risk of price declines in that scenario, but the industries most affected would likely reflect the worst geographic stresses. For example, if China’s economy were to stumble with a repricing of the risk in their banking system, that could have a larger impact on other emerging economies and raw commodity prices than if the Eurozone economy faltered with the UK in the aftermath of Brexit.

What are practical implications for a U.S. investor’s portfolio?

From an asset class perspective, after a “flight to safety” response from investors in the immediate aftermath of the UK referendum, its clear that high-quality bonds are still an important portfolio ballast that may provide diversification when risk assets such as stocks correlate highly. Traditional safe-havens such as gold have also fared well. However, for long-term investors, extremely low yields on government bonds may make stocks an attractive value relative to Treasuries.

With respect to equities, large, multinational companies who earn in multiple currencies may be more sensitive to the effects of Brexit, whereas companies that derive more of their earnings in U.S. dollars – including smaller capitalization companies – may be relatively insulated from the negative impact of a stronger dollar.

Moreover, active management has the potential to add value in an environment where earnings are likely to be impacted by the U.S. dollar amidst increased headline risk, and with an uncertain outlook for global growth.

For more information please contact our Advisor Support Team at (844) 747-5292 or email us at info@americanindependence.com. To contact the author, please email cmcnally@manifoldfundadvisors.com.

1The Associated Press. “The Latest: Bank of England Head ‘Can’t Protect From Pain.’” ABC News.com, http://abcnews.go.com/International/wireStory/latest-french-fm-eu-deal-scotland-40240889. Accessed July 11, 2016.
2“Monetary Policy Summary.” By the Bank of England, July 14, 2016, http://www.bankofengland.co.uk/publications/minutes/Documents/mpc/mps/2016/mpsjul.pdf. Accessed July 14, 2016.
3Douglas, Jason and Paul Hannon. “Bank of England Cuts Key Interest Rate to New Low.” The Wall Street Journal.com, August 4, 2016, http://www.wsj.com/articles/bank-of-england-cuts-key-interest-rate-to-new-low-1470309155. Accessed August 4, 2016.
4“Economic Forecasts for United Kingdom Real GDP (YoY%).” Bloomberg Economic Forecasts (ECFC) [subscription service], August 2016 survey. Accessed July 29 & August 22, 2016.
5Krantz, Matt. “Companies: How Brexit will actually affect us.” USA Today, July 6, 2016, http://www.usatoday.com/story/money/markets/2016/07/06/companies-how-brexit-actually-affect-us/86712618/. Accessed July 11, 2016.

Definitions

Gross Domestic Product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.

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Important Disclosures

The views and opinions expressed in this article are for informational purposes only, not for the purpose of providing investment advice, are those as of the date of the article and are subject to change over time or at any time. Active management does not assure a profit or protect against loss. The investment strategies discussed are not appropriate for every investor and investors should review with their advisors the appropriateness of any investment strategy. Manifold Fund Advisors, LLC makes no guarantees on the completeness or accuracy of information provided herein.

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