June 24, 2016 - A historic vote occurred yesterday, resulting in the largest move in the European Union (EU) since the formation by the 1993 Maastrict Treaty. The citizens of the United Kingdom voted to leave the EU, setting the stage for significant actions for years to come.
The immediate response is reflected in the financial markets. The British pound and euro both weakened. After falling over 10% initially, the pound currently is down approximately 8% versus the US dollar, and the euro is down about 3%. The stronger dollar inversely influences the direction of both oil and interest rates. Presently the 10-year U.S. Treasury is yielding about 1.50%, down from 1.70% on Thursday. Globally, stock markets have fallen as the week’s trend of “risk on” violently reverses to “risk off”. Interestingly, the UK market (FTSE) is one of the best performing European markets, down less than 5%, with Spain off 13%, and even Japan down 8%. U.S. equities opened in the red. With the U.S. stocks up meaningfully for the past weeks, the expected sell-off would bring us back to levels of a week ago.
This outcome reflects a growing trend of political populism and nationalism throughout Europe and the United States. The British outcome places greater focus on this weekend’s Spanish general election vote. One concern is whether this is the beginning of a domino effect where other nations reject the European project and seek to leave the EU. In response to the make-up of the U.K. vote, where Scotland and Northern Ireland voted overwhelmingly for “remain”, many have suggested this could lead to the breakup of the U.K.
The other immediate impact is the change in British leadership, with Prime Minister David Cameron announcing he will step down following an election to determine his successor.
The steps for the U.K. to actuate this divorce will take longer than many realize. The vote is just the first step which triggers Article 50 of the Lisbon Treaty that outlines the formal process of leaving the EU. The treaty indicates a minimum two-year process for negotiating treaties and exit preparation. Several informed participants indicated that this could take up to three years before the actual exit. Knowing all of the implications is impossible at this time and will evolve over the months and years to come. The uncertainty will likely subdue U.K. and EU growth, but there will be winners – one to keep an eye on is Ireland.
The lasting impact on U.S. growth and markets is difficult to estimate, but where the U.S. dollar stabilizes and the extent of financial tightening in the Brexit aftermath will provide insight. The dollar’s strength over the past 18 months has slowed the growth of trade and earnings for global-focused U.S. companies. This will be offset by lower rates, energy prices and global central bank liquidity. It reduces the likelihood of Fed action over the remainder of the year. Our firm’s view is that the probability of a U.S. recession remains low and this could be a buying opportunity for risk assets as most markets may potentially overreact to England’s decision to leave the EU.
We will continue to monitor events but do not expect significant changes to our current strategies. Our focus on principal protection and consistent returns is unchanged. Our fixed income portfolios have been positioned for elevated volatility for over a year, with an emphasis on credit weighted toward domestic growth and less vulnerable to a stronger dollar. For our arbitrage strategies, lower rates and slower growth may drive continued deal activity as companies consider ways to drive shareholder value during periods of light organic growth. Within the arbitrage portfolios, between cash on hand and near-term maturities, the portfolios are well-positioned to opportunistically redeploy capital into this prospective market weakness.
As changes occur or outcomes vary from our present expectations, we will convey that to clients and consultants. In the interim, we are available to respond to questions and concerns.
The opinions contained in this study are those of Longfellow Investment Management Co. (LIM) as of 06/24/2016 and may vary as market conditions change. They are based on information obtained by Longfellow from sources deemed to be accurate and reliable. However, accuracy is not guaranteed. Reliance on information in this study is at the discretion of the reader. The information provided does not constitute investment advice, is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy and should not be relied upon as such It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. There is no guarantee that any forecasts contained herein will come to pass. It is in the sole discretion of the reader whether to rely upon the opinions contained in this study.