Britain’s decision to exit the European Union was a shock to many and has brought with it all the expected trappings of a wild news event – projections of crazy market volatility, doom gloom, recessions and wild headlines.
Many questions immediately arise as we pay close attention to how the event will play out in the weeks and months to come. But our perspective is the same as it has always been in times like these. Your financial plan is built with diversification and your personal risk tolerance in mind — it’s designed to weather the ups and downs that inevitably follow significant world happenings.
1. What did British voters decide?
To the surprise of many – including stock and bond markets – Britain voted to leave the European Union (EU) by a margin of 52 percent in favour of leaving (i.e., “Brexit”) and 48 percent in favour of remaining. The general belief from the economic community is that this decision will weaken the British and European economies since Britain both imported and exported a significant amount of its economic consumption and production, respectively, to continental Europe.
2. How have markets reacted?
At the time of this writing, stock markets have fallen and bond interest rates have dropped as well. With the exception of precious metals, commodity markets are also generally down, and the Pound has dropped by about 8 percent against the U.S. dollar.
3. Why have markets reacted so violently?
Without question, the primary reason is that markets had incorporated a belief that Britain would remain in the EU. Stock markets had been up significantly over the last couple of weeks, and interest rates had started to move back up after being lower earlier in the month. These movements were generally believed to be an indication that the market expected Britain would remain in the EU.
Because the vote did not go as most expected, stock markets are giving back those gains and more, and interest rates are now falling instead of increasing. I should emphasise, though, that while these market moves have been swift, this is normal market behaviour when a significant event (like Britain leaving the EU) turns out differently than what the market had anticipated.
4. Why have the international markets reacted so strongly to Britain’s decision?
We truly live in an interconnected, global economy at this point. Any decision by an economy that is the size of Britain’s (fifth largest in the world) will impact markets elsewhere, including the U.S. market. The European market is a significant trading partner for many U.S. firms, so it’s not surprising to see U.S. and international stocks decline since Britain’s decision is thought to be a net negative for Europe from an economic perspective.
5. Will Britain’s decision precipitate a global recession?
It’s impossible to say whether we are headed toward a recession, but Britain’s decision likely increased the likelihood of a recession. However, the strong caveat here is that markets are forward looking and have already started to incorporate this likelihood, meaning you can’t use this information to your advantage. This increased likelihood of recession is no doubt one of the reasons that stock markets have moved down sharply while bond prices have moved up sharply.
6. How did markets get this wrong?
While outguessing markets is difficult, in hindsight markets will always appear to have been overly optimistic or pessimistic, which means it’s easy to critique them while looking in the rearview mirror. This particular vote was expected to be close, so markets weren’t certain but were trending toward a “remain” vote.
7. What will markets do from here?
While it’s very difficult to predict markets, it is highly likely markets will be volatile for some time to come. Stock market volatility has been relatively low over the last few years, but it can change quickly. The VIX, which is a measure of annualised stock market volatility, has gone from about 17 percent to 25 percent in reaction to the news, which is higher than the long-term average of about 20 percent per year.
It is important to remember, however, that higher volatility can work in both directions. While we could certainly see more days when stocks fall significantly, it’s also possible we will have days when they rise significantly.
8. What should I do with my own portfolio?
Our guidance is the same that it has always been. If you have built a well-thought-out investment plan that incorporates your ability, willingness and need to take risk, you should not change your plan in reaction to market events. Doing so rarely leads to productive results.
Your plan incorporates the certainty that we will go through periods of negative market returns, and market reactions like this are also the primary reason we emphasise high quality bond funds and bond portfolios, which help buffer the risk of stocks. The early read on this bond approach is that it’s doing exactly what we expect it to since high quality bonds have appreciated significantly in reaction to the Brexit vote.
9. How will this impact interest rate policy?
As we have previously noted, interest rates have dropped dramatically in reaction to the vote. At the closing bell on Friday, the 10-year yield was at about 1.088 percent after having been at about 1.376 percent one day earlier. These early movements in interest rates indicate the market does not expect the Bank of England to increase interest rates at any point during the rest of the year. The primary ways this would likely change are either an unexpected increase in the rate of inflation or unexpectedly positive developments in the British and global economy.
10. Do international and emerging markets stocks still deserve a place in a well-diversified portfolio?
International and emerging markets stocks comprise more than half of the world’s equity market value, so we continue to believe that a well-diversified stock portfolio should include a significant allocation to international and emerging markets stocks. While both have outperformed British equities over the last 10 years – international also over five years, that does not mean they will continue to do so. We have seen periods in the past when British stocks have outperformed international and emerging market stocks for a long period of time only for that to reverse in the future.
11. What role do currencies play in this situation and in my portfolio?
Initially, we are seeing the British pound depreciate against the Euro and U.S. dollar. The international equity funds we use do not hedge foreign currency, so when the British pound depreciates relative to other currencies, this positively impacts their returns. The long-run academic evidence, however, shows that hedging currency risk has minimal impact on an overall portfolio and that it can be beneficial to have exposure to currencies other than the British pound for a portion of an overall portfolio.
12. Yield Curve
A yield curve shows the yield or ‘interest’ payable on varying term fixed interest securities (typically Gilts/government bonds). Shorter term normally have a lower yield than longer term fixed-interest securities.
Research beginning in the late 1980s documents that the slope of the yield curve is a reliable predictor of future real economic activity i.e. a recession predictor. Today, a substantial body of evidence exists from which various useful stylised facts have emerged.
An inverted yield curve is often a predictor of a recession. At present, although the reducing, the 3-month yield vs 10-year yield remains positive. Typically yields become inverse or the difference is negative 3-6 months before a recession occurs.