Insights & Thoughts

Understanding Brexit – Sell First, Ask Questions Later

by | Jun 16, 2016 | Market Related

The British people just voted to leave the European Union.  In response, global stocks are staging a huge sell-off. Similarly, U.S. Treasuries rallied as investors sought safety. The short-term market response to the vote seems universally negative, but does that mean Britain’s exit is a bad thing? Not necessarily.

First, a little background on the vote. The European Union was first proposed as a monetary union to form a common currency in order to make trade and travel easier throughout the continent. But in order to create a common currency, political policies needed to be harmonized so that all the member countries played by the same rules. The result was the creation of a new governmental entity that in many ways displaced each country’s sovereignty. The EU dictated everything from monetary policy to how a box of cereal must be labeled. That was a tough pill to swallow, but considered a price to pay for the hoped economic growth that would come from a powerful EU.

Over time, however, the EU’s bureaucracy has grown to a point where it meddles in every aspect of life. There has always been friction, but lately those tensions have really come to a head from the financial bailouts of countries like Greece and more recently, immigration. The North African and Syrian refugee crises was the tipping point that led to the British vote.

So is the market telling us that the decision to leave was a mistake and the financial fallout is dire? After all, we’re told the markets are efficient and prices reflect the collective wisdom of the crowd. Well that’s true – sort of. This is where the distinction needs to be made between long-term trends and short-term volatility.

As a refresher, the fair value of a stock’s price should be the present value of the future earnings of that company. If you’re looking at an index like the S&P 500, that would be the present value of the collective future earnings of those 500 companies. There are only two variables in the equation – expected earnings and the discount rate (interest rate). That’s it. The long-term price performance of any stock will be driven by changes in those two things. There are, however, a lot of other things that can affect those two variables and this is where volatility comes from.

Mathematically, small changes in future expectations, which can be very subjective, can result in big changes in the calculated price. This is why the markets hate uncertainty. If one analyst thinks one thing about earnings and another analyst concludes something else, the resulting price forecast can be quite different in the short-term. The longer-term price trend will be driven by the actual earnings results. This is where the short-term and long-term diverge. Short-term price movements are driven by educated guesses and long-term price movements are driven by what actually happens. When you have a big event occur, of which the impact is unknown (i.e. the British exit), there really is no way to correctly calculate the market’s fair value. The herd mentality is to sell first and figure it out later. That’s what traders do. It’s not what investors should do.

Here’s what we know about the British situation. Under the EU domain, Britain was unable to control such things as their immigration, energy policy and money supply. They were forced to use their tax dollars to bail out the debt obligations of other less responsible countries. Britain’s exit costs the EU bloc one of its wealthiest members and one of its biggest military powers. It could take upwards of two years to disentangle itself from EU institutions. Britain’s trade deals will need to be renegotiated worldwide. For sure, this will be chaotic at first.

Uncertainty will translate into market volatility, however, this will subside as the picture comes into focus. Longer-term, we believe this will lead to higher economic growth in Britain as their economy frees itself from the bureaucratic and regulatory burdens. This would be a very good thing for a country that is 5th worldwide in GDP.

The larger question is what impact will this have on the EU? Britain was the second largest member of the EU. Its absence will be felt and puts into question the long-term viability of the EU. Once again, what would a EU break up mean? It has always been a less than perfect union. Maybe it is time for this grand experiment to end. From the U.S. perspective, the EU had originally been proposed as a counter to U.S. economic dominance. This has clearly not come true. So longer-term, our market status remains unthreatened. In the short run, it’s very likely the Federal Reserve will be forced to put their rate hike plans on hold for the foreseeable future.

 

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