The British vote to leave the European Union reverberated throughout financial markets on Friday, mostly in predictable ways. Sterling dropped 8.1% vs. the dollar to a 35-year low of $1.37 at Friday’s close, while the euro shed a more modest 2.4%. The U.K. stock market dropped 3.1% in sterling terms, but that move is magnified when the weakness of sterling is taken into account.
The U.S. stock market shared in the pain as the S&P 500 declined 3.6%, dragging the index back into negative territory year to date. Gold rallied to $1,315 per ounce, and interest rates plummeted. The two-year Treasury yield slid from 0.78% to 0.63%, and the 10-year yield dropped from 1.75% to 1.56%. All in all, it was a classic “risk-off” trading session in which investors sought the traditional safety of the dollar, Treasuries and precious metals at the expense of just about everything else.
Following the last meeting of the Federal Reserve, Chairman Janet Yellen referred explicitly to the potential market disruption from Brexit and admitted that the Fed had taken this risk into account when considering a June rate hike. Following her cue, as of Friday’s market close, the futures market now assigns a 0% probability to a Fed rate hike in July or September, with the probability of a November hike inching up to 1.9%. The last meeting of this year is in December, and the probability of a hike then is only 15.3%. Fed watchers can take the rest of the summer and most of the fall off.
The political aftermath of the referendum continued to unfold throughout the weekend. Prime Minister David Cameron announced that he would resign his position before the Conservative Party conference in early October on the grounds that a leader in favor of leaving the European Union ought to manage that process. Labor Party leader Jeremy Corbyn, who also supported Britain’s continued membership in the EU, has held onto his leadership role so far in spite of the resignations of 11 members of his shadow cabinet. It remains to be seen how tenable his position is.
Boris Johnson – the former mayor of London, vocal supporter of Brexit and leading candidate to assume Cameron’s role as leader of the Conservative Party – sounded on Friday like the dog that finally caught the car, only to be unsure of what exactly to do with it. In comments to the press over the weekend, Johnson preferred a delay in implementing Article 50, probably in recognition of the fact that, once invoked, Britain only has two years to complete the negotiations for departure. The European Union, on the other hand, is eager to get on with it. European Commission President Jean-Claude Juncker told a German newspaper on Saturday that “the will of the British people must now be put into effect as quickly as possible.” These negotiations will not be easy.
And yet the biggest surprise on Friday was something that didn’t happen: Britain didn’t actually leave the EU. Article 50 of the Treaty on European Union, as vague as it is, acknowledges that “any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements” and that said member state “shall notify the European Council of its intention.”
In the days leading up to the referendum, Prime Minister Cameron repeatedly stated that the British people had the right to expect that the United Kingdom would provide that notification immediately following a vote to leave. Whether that statement was part of the campaign theatrics or Cameron had a change of mind, the fact is that the United Kingdom remains a full member of the European Union unless or until it notifies the European Union otherwise. Cameron has evidently chosen to leave it to his successor to figure out how to proceed and when to notify the EU of Britain’s intent to leave. It is, furthermore, not entirely clear what “constitutional requirements” apply to a nation that does not have a constitution. A new prime minister may choose to seek approval from Parliament before triggering Article 50, which would delay departure even further. What is clear is that the next step lies solely with the United Kingdom. Notwithstanding Juncker’s desire to start divorce proceedings yesterday, he and the Commission can’t do anything until formal notification is received from the U.K.
The biggest plot twist to come out of this is that Britain might not follow through on the referendum. Yes, it is almost unthinkable that a future prime minister or Parliament would not act on the referendum outcome, but even in the hours following the results, a certain amount of “bregret” began to set in. The lack of an immediate Article 50 notification and Boris Johnson’s comments about slowing down the process stand as evidence of that. Scotland and Northern Ireland, both of which voted to remain within the EU, have started to explore ways to preserve their membership. Scottish voters opted to remain part of the European Union by a vote of 62% to 38%. Recall that in 2014 Scotland voted to remain part of the United Kingdom, and First Minister Nicola Sturgeon has already committed to a second referendum on the issue if the U.K. leaves the EU. Sturgeon has furthermore hinted at leveraging the Scottish Parliament to block any U.K. motion to enact Article 50.
Across the Irish Sea, British citizens in Northern Ireland similarly voted (by a margin of 56% to 44%) to stay in the EU, and the referendum has sparked new talk of the old idea to reunify Northern Ireland with the Irish Republic. What has for decades been a conflict between Catholics and Protestants may evolve into a conflict between being part of the EU or the U.K. The decision to leave the EU, if implemented, will alter the European economy in unpredictable ways – and could easily alter the U.K. economy in ways equally unpredictable.
It is possible that political disarray in Britain leads to a general election. If candidates for leadership distinguish themselves by their desire to carry through with the leave vote or ignore the referendum and remain within the EU, and if the “remain” candidate wins a general election, Britain might conclude that this outcome supersedes the referendum and never invoke Article 50. The possibilities abound.
The proliferation of “ifs” and “possibilities” in this article prove that the only thing we know for sure is that we don’t know anything for sure. These developments certainly warrant attention and clearly hold the possibility or even probability of driving price volatility as progress takes the inevitable step (or two) backward after a step (or two) forward. Investors therefore face a challenge: We must either seek a clearer crystal ball into the likely path of future events or learn to invest in a state of perpetual uncertainty. The future is forever an unknowable place, and these unprecedented events rob us of our ability to appeal to history as a guide. At Brown Brothers Harriman, we choose to invest in a way that does not rely on knowing the future better than our competition but relies instead on a fundamental (and conservative) estimate of intrinsic value,1 coupled with a purchase discipline that seeks to establish a margin of safety2 by acquiring assets at a discount to that value. Price volatility therefore becomes our friend – not our enemy – as it creates the opportunities to implement this investment discipline. We follow these principles in building portfolios for our clients, whether at the direction of our own analysts or through the various investment managers with whom we partner.
These next few weeks and months will undoubtedly be trying times for investors and clients. You may rest assured that we will adhere to our investment discipline and will continue to provide commentary as these most unusual events unfold.
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© Brown Brothers Harriman & Co. 2016. All rights reserved. 6/27/2016.
1 Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
2 Margin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.