Months of debate between the Brexit and Bremain camps have culminated in a brave new world in which the United Kingdom – by a vote of 52% to 48% – has decided to part ways with the European Union.
Financial markets are casting their own votes, and they’re not happy. Earlier today, sterling hit its lowest level vs. the dollar in 30 years and as of 7:50am EST was down 8% to $1.37. The euro is also weaker vs. the dollar, down 2.9% to $1.105. The UK FTSE 100 is down close to 4.4%, and S&P 500 futures are down 3.7%. The stronger dollar is a sign of a classic flight to safety, mirrored in a drop in two-year Treasury yields from 74 basis points to 60 basis points after the results were clear. The benchmark 10-year yield has dropped from 1.75% to 1.52%, and spot gold prices are up 5% to $1,325 per ounce. CBOE volatility index (VIX) futures have spiked from a Thursday close of 17 to over 24. Friday will make for interesting trading.
What Next for Europe?
U.K. Prime Minister David Cameron promised to hold a referendum on EU membership as part of his successful campaign for re-election in May 2015. Given that commitment – as well as his staunch support of EU membership – he has resigned as prime minister and will be out by October. The conservative party will select a new leader, with Boris Johnson, the former mayor of London and passionate voice for leaving the EU, as his likely replacement. Johnson inherits a difficult job. Technically, this referendum is not legally binding, but it is hard to imagine the U.K. government not acceding to the wishes of the populace on such an emotional issue. Now the hard work begins.
Divorces are always messy, and more so when there is no prenuptial agreement. The mechanism for a country leaving the EU is spelled out in the rather brief Article 50 of the Lisbon Treaty on European Union. The article vaguely acknowledges that “Any member state may decide to withdraw from the Union in accordance with its own constitutional requirements,” but then rather more vaguely states that the departing country should “notify the European Council of its intention,” and “negotiate and conclude an agreement … setting out the arrangements for its withdrawal … .” It seems clear that the drafters of the treaty didn’t anticipate that a member state would actually ever leave, figuring that if it ever happened they could just make it up as they went along. The referendum itself is not tantamount to notifying the EU of the U.K.’s desire to exit the union, so the first step will be to figure out how and when to provide that notification. Expect a cacophony of opinions on how this should or will happen, no one of which will be more informed than the other.
The treaty provides for a two-year period to figure all of this out, and it will take all of that time to negotiate (or renegotiate) regulations across the span of an economy, trade tariffs with the EU, immigration issues, financial market regulations and a host of frameworks from which the U.K. has voted to secede. At the same time, the U.K. will need to contend with the fact that 48% of the population (or at least those who voted on Thursday) are against all that is about to take place. This is both a domestic and international issue for the United Kingdom.
What Next for Investors?
Unless and until the process of separation becomes clearer, investors will have to contend with heightened uncertainty on the global economic stage, and financial markets despise uncertainty. To make matters worse, in an environment of weak corporate earnings growth and lofty valuations, U.S. financial markets are already primed to overreact to external developments. This is a big external development, and U.S. financial markets – even though not directly exposed to a redefinition of Europe – are likely to experience heightened price volatility for some time to come.
This is where risk management pays off. A deep appreciation of fundamental risk requires robust security analysis, an identification of what might go wrong and how likely it is that capital would be permanently impaired. This analysis defines the intrinsic, or fundamental, value of an asset. Our managers generally prefer companies that have a greater-than-average degree of control over their own destiny, by virtue of market position, the essential nature of their products and services, their geographic diversification, brand value, or some combination of all these factors. The U.K. decision to leave the EU isn’t a great day for our portfolio companies but is less impactful on companies that share these characteristics.
In order to manage price risk, a disciplined investor will only acquire a security at a discount to the intrinsic value of the underlying asset. The disciplined investor with liquidity can therefore benefit from heightened price volatility, as it provides the opportunity to acquire quality assets at an appropriate discount to intrinsic value. There is a difference between price and value, and investors will likely be reminded of that repeatedly over the next few trading sessions.
We will continue to write and speak on this truly unprecedented event as details unfold, all the while keeping in mind that patience and discipline are the hallmarks of successful investing.
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