UK voters shocked the world last night by voting, in a surprise, to leave the European Union. The nation will be the first to leave the 28-nation bloc, of which it has been a member since 1973. The vote was followed by British Prime Minister David Cameron’s announcement that he will resign, and by global equity markets declining meaningfully. In the UK itself, substantial losses early in the day have partially reversed course, and in local currency terms the FTSE 100 index is up more than 2% this week.
In a flight to safety, both the US dollar and US Treasury bonds have posted meaningful gains. The 10-year Treasury yield briefly fell below 1.5%, its lowest level since 2012. The British Pound plunged to a 30-year low versus the US dollar, declining 6% in the first trading day following the vote. This decline represents the currency’s worst day in its history.
While the EU represents approximately 24% of global GDP, or total economic output, the UK represents only 2.4% of global GDP.
As of 12 pm pacific time, today’s returns for various indexes stood (all in US dollar terms):
|Market||Index||Local Currency Return||Return in USD||Lowest Index Level Since (USD)|
|US Large Cap||S&P 500||N/A||-2.9%||6/17/2016|
|US Small Cap||Russell 2000||N/A||-3.6%||5/23/2016|
|Non-US||MSCI ACWI ex US||N/A||-2.8%||4/7/2016|
|Non-US Developed||MSCI EAFE||N/A||-7.7%||2/29/2016|
|United Kingdom||FTSE 100 (GBP) & MSCI UK Index (USD)||-3.1%||-11.1%||2/24/2016|
|Germany||DAX (Euro) & MSCI German Index (USD)||-6.8%||-9.9%||2/24/2016|
|France||CAC 40 (Euro) & MSCI France Index (USD)||-8.0%||-11.4%||1/20/2016|
|Spain||IBEX 35 (Euro) & MSCI Spain Index (USD)||-12.4%||-16.1%||7/24/2012|
|Italy||FTSE MIB (Euro) & MSCI Italy Index (USD)||-12.5%||-14.9%||7/26/2012|
|Emerging Markets||MSCI EM||N/A||-6.0%||5/24/2016|
|US Treasury Yield||10-Year Treasury Bond||N/A||1.6%||6/16/2016|
Note that the UK market has declined today only 3.1% in local currency terms, but after accounting for the British pound’s decline against the US dollar, the loss is magnified to -11.1%. Currency aside, the large magnitude of today’s losses in the UK and other European markets is substantially the result of unwinding the run-up that took place prior to the Brexit vote, as investors bet that the UK would choose to remain in the EU. The rightmost column in the above table shows that while today’s losses are significant, in most cases the indexes (with the notable exceptions of Italy and Spain) are merely reverting to recent levels.
The amount of market volatility suggests two things: first, that the outcome of the British vote to leave the EU was a surprise, and second, that market participants are still digesting the implications of the vote. While we are doing so as well, we offer a few points for consideration:
First, the vote itself does not trigger any immediate action to separate Great Britain from the European Union. The vote merely represents the will of a deeply divided nation to leave the EU. It will be up to the next Prime Minister, whomever that will be, to invoke Article 50 of the Treaty of Lisbon, which outlines a two-year procedure for a nation’s exit from the Treaty, and the European Union.
While markets were surprised by the vote to leave the EU, the process from here forward is more clear now that the decision has been reached. The terms of exit will be messy – they will be negotiated between Britain and its 27 EU counterparts, each one of them holding a veto – but the endpoint is more certain. Markets do not deal well with surprises, as evidenced by today’s volatility, but to the extent the political path toward Great Britain’s exit from the EU is less surprising than the vote itself, we expect markets to absorb that news in a more orderly way. The fact that no exit will occur for at least two years, and that any decisions made from here will be less dramatic than the decision to leave the EU, makes us believe that near-term volatility should subside.
The vote brings a cloud of tremendous economic uncertainty over Britain and Europe. Great Britain could very well fall into recession after withdrawing from its largest trading partner. Today’s declines in peripheral European countries suggest that their economies may be hit hardest. Markets, however, do not always follow economies. European markets entered this political crisis at deeply discounted valuations, some of which reflected broad uncertainty and the potential for events like this one in the region. The market losses associated with future economic losses may have already occurred.
Which is all to say that today is a dramatic day in the markets, but our sense is that future days will be less dramatic.
We have long advocated for globally diversified equity portfolios precisely because no single country or even region should dominate a portfolio’s returns. While today that global portfolio diversification is detracting from portfolio values, we believe the concept of geographic diversification remains sound. The world outside the United States accounts for 84% of global economic output (as measured by GDP) and 47% of global stock market capitalization. Political events cause near-term stress, but valuations win in the long run.
In late 1939, just after the outbreak of the second World War, the British Government formed a new department, responsible for publicity and wartime propaganda, and tasked it with an outreach campaign designed to boost morale across the country. Its campaign centered around a simple phrase: “Keep calm and carry on.” Wise words for today as well, in our view.