The Reality of the Brexit: What Now?
“The British are leaving! The British are leaving!”
In a 52% to 48% vote, the citizens of Great Britain opted to say “cheerio” to the European Union last week, on June 23rd, stunning financial markets all over the world. Though it will be a long goodbye, taking two years or more to finalize, the fallout has already begun
Surprisingly, the market players were completely offside on this referendum. It seemed like every time members of the authoritatie elite – politicians, media, economists, corporate titans, etc. – opened their mouths, the Leave camp grew stronger. But market participants only acknowledged facts that fit their agenda, ignoring whatever facts did not coincide with their position to stay.
For example, while 68% of the money bet with British bookies were placed in favor of remaining in the EU, 69% of the individual bets called for the Brexit. In other words, the rich were betting on ‘remain’ but they were not turning out in the highest numbers to make this call. Instead, the average person on the street – the majority of British citizens – was putting their money on ‘leave’ because they knew how their peers and colleagues were voting.
Ultimately, the typical U.K. citizen fed up with the status quo turned up in droves and stormed the “castle” of the establishment.
Counting the Losses
This being “offside” resulted in immediate financial reaction. By the 24th, the market fell over $2 trillion in market valuations – the single largest daily drop in valuations since 2007.
And the wreckage is a bloody mess.
In Britain, 10-year gilts traded at a record low yield (1.02%) and the pound fell by 8%, at one point falling to its lowest level versus the U.S. dollar since 1985.
In Europe, stock fell sharply, with the main Stoxx 600 index dropping about 7% – Germany was down 6.8%, France 8%, as well as about 12% in both Spain and Italy.
Additionally, the yield on the 10-year German bund fell to -0.056% and the euro fell by 2.2%.
Inversely, the Japanese yen, Swiss franc, and U.S. dollar all soared, and gold skyrocketed by $60 an ounce. Plus, the U.S. 10-year Treasury yield settled at 1.56%.
But of course, U.S. stock markets fell, doing damage to Dow Industrials -3.39%, S&P 500 -3.59%, and Nasdaq -4.12%.
What’s to Come
The average investor is surely wondering where to turn now.
I’m reminded of the famous Yogi Berra quote: “It’s tough to make predictions, especially about the future.” Nevertheless, it’s paramount that analysts take a swing at what’s to come, even if it’s a swing and a miss.
Some will focus on what country will be next in Europe to walk away from the EU. Denmark (Dexit) and the Netherlands (Nexit) are two likely names that will surface in that discussion.
One major uncertainly remains: more countries could leave the EU, but the odds are longer than they were for Britain.
Keep in mind, the United Kingdom was never fully integrated into the EU, even though it has been a member since 1973. It even opted not to adopt the Euro in favor of keeping the pound. For other countries that may want to leave, the process will be a harder and longer when a currency exchange is involved, despite what their citizenries may want.
Additionally, many in Europe don’t want to quit the Union. In the Spanish election Sunday, the Podemos party, which is pushing to leave the EU, finished a disappointing third.
As far as the financial markets go, the Brexit just reinforced some existing trends.
Interest rates around the world will be lower for longer. The Federal Reserve will not raise rates. And I still maintain the next move is lower. The 10-year Treasury yield will continue its march toward 1.25% and possibly lower.
Gold and silver will continue higher too as more investors lose faith in central banks’ abilities.
With stocks, investors in passive index funds will be losers. The reason being that financial stocks are the epicenter – as they were in 2008 – of the problem and they make up a large portion of most major indexes.
Just look at Friday’s carnage: Morgan Stanley – 10%, Citigroup – 9.4%, Bank of America – 7.4% and Goldman Sachs – 7%.
Plus, Stoxx Europe 600 Bank index plunged 14% and hit its lowest level intraday since August 2012!
In the U.K., Barclays dropped 20% and Lloyds 21%. In continental Europe, Deutsche Bank and Credit Suisses both fell 14%, Spain’s Banco Santander dropped 20%, and Italy’s Unicredit plunged 23%.
How to React
So what is the next move for investors?
It’s not too late to check asset allocation and re-balance, for starters.
The brutal Brexit reaction shows that, if you own stocks, you should have bonds and gold in your portfolio as an insurance policy against stock risk. Both gold plays and bond plays like the iShares 20+Year Treasury Bond ETF (TLT) did extremely well in the midst of the selloff.
Do not listen to the siren calls of the hucksters on CNBC and elsewhere that tell you to now put everything into U.S. stocks because Europe is doomed. Remember, these are the very same people that never saw Brexit coming.
My 30 years of experience taught me that there is something called a reversion to the mean or, as a technician friend of mine calls it, “the lines converging again.”
U.S. stocks have drastically outperformed their overseas counterparts – despite the S&P 500 flat lining for the last 24 months. Europe, Japan, and some emerging markets are in deep bear markets, down 20%, 30%, and 40%.
It’s a near certainty that the performance of these markets will meet up with U.S. markets. Probably sooner rather than later.
I’m reminded of the advice of legendary investor, Sir John Templeton: “Buy when others are despondently selling and sell when others are avidly buying.”
He would often say, “People are always asking me where the outlook is good, but that’s the wrong question. The right question is: Where is the outlook most miserable?”
“Miserable” can be used to describe most markets outside the U.S.
If conditions improve, these markets will have to play catch-up and investors will want to be in those overseas markets for the much larger gains.
Or, if things turn south, the U.S. market will be forced to play catch-up on the down side with these markets. That still means overseas markets will outperform on a relative basis.
So don’t be afraid to invest in foreign markets while maintaining a core in the U.S.
But always remember: an index fund will not do the trick. Instead, either go with an actively managed fund or hand pick stocks yourself.
It’s not hard. Just look at Europe, for example, at the beaten-down quality blue-chip names.
These include well-known companies such as: Nestle SA (NSRGY), Unilever PLC (UL), Reckitt Benckiser Group PLC (RBGLY), L’Oreal SA (LRLCY), Adidas AG (ADDYY), drinks giant Diageo PLC (DEO), and fashion powerhouse Inditex (IDEXY), which is best known for its Zara brand.
There is a way out of this Brexit mess but it requires keeping your wits about you and making smart moves amongst a minefield.
Slowly building positions in quality names like these will turn out to be a winning trade.