Brexit – July 2016

July 19, 2016

Dow Jones Average: 18,559
S&P 500 Index: 2,164


Citizens of the United Kingdom stunned the world by voting about a month ago to leave the European Union. The decision (referred to as Brexit) was the clearest example to date of the populist wave gaining traction in many regions of the world. All of these populist movements have their roots in the financial crisis of 2008, and can be seen as a broad rejection of globalization. Whether the anger is directed at central banks and the financial sector, free trade pacts, or immigrants, the message from many voters this year has been to step back from the free movement of capital, goods and labor that defines globalization. Many people have become economically discouraged in recent years, from young graduates with significant debts and few job prospects, to older workers whose skillsets are not as relevant in a rapidly shifting, technological economy. Politicians on both the left and the right have tapped into voter frustration by railing against some aspect of globalization. Britain’s vote to leave the European Union was simply the loudest statement in this general protest.

Investors are understandably nervous about the economic implications of the antiglobalization trend. Stock markets are dominated by multinational companies, all of whom benefit from increased globalization. Their goods and capital flow freely across national borders to an ever-larger base of consumers. It is no surprise that stock markets fell sharply in the wake of Britain’s vote. Investors bailed out of assets perceived as risky, such as stocks and the British Pound, and moved into the safe haven of U.S. Treasuries, the Swiss Franc and Japanese Yen. The yield on the ten-year U.S. Treasury fell to 1.3% after the Brexit vote, while yields in many other developed economies went to less than 1% on ten-year paper. The desperation investors feel when it comes to making a return on capital was exacerbated by the fallout from the referendum.

The drop in stock prices was dramatic but brief, as fear of what might happen to Britain and the world economy some years hence was overshadowed by the immediate decline in interest rates to new, all-time lows. For much of this year investors have been flocking to stocks in stable industries, such as consumer, food, and medical, that pay out substantial dividends. The movement of investor dollars to economically defensive sectors that carry larger dividends turned into a mad dash after the Brexit vote. The stock market simply mirrored the bond market, with any companies that look and feel like a bond doing very well. The five percent market decline that followed the referendum turned rather quickly into a rally led by utility, telephone, consumer, and medical stocks. The valuations on economically defensive companies have become extremely high, in many ways reminiscent of the absurd valuations placed on tech stocks during the tech mania of 1999-2000.

The world is increasingly defined by extreme financial policy and subsequent reactions, from central banks establishing negative interest rates, to massive debts taken on by countries to save their economies, to stock market valuations that strain credulity, and political extremism that reflects the public’s worry over being marginalized in the process. We have long felt that part of the energy for movements such as the “Tea Party” in the U.S. has come from the negligible returns on money held by the less-sophisticated investors who primarily hold C.D.’s and bank deposits. Ultra-low interest rates may have been necessary to rescue the economy from the Great Recession of 2008, but that reality is still harsh for those with modest savings in C.D.’s. Middle and lower-middle income citizens of other countries are feeling the same economic pressures, which has been expressed in the U.K. by the Brexit vote.

Current Strategy

The stock market has been hit with two bouts of panic selling in 2016, but has bounced back quickly from both episodes. Worries about a slowdown in China, currency wars, and politics have been overshadowed by interest rates that have gone even lower. Very few thought that rates could go lower, because they were already at rock bottom. But rates have moved lower on longer-dated bonds, while going negative on short-term paper in several countries. Investors faced with the prospect of no return on fixed income, and a scary global economic picture, have opted for the perceived safety of big, dividend paying stocks in very static industries.

If taken too far, treating stocks as if they are bonds can be dangerous. Stocks represent shares in companies that have to compete with other companies in a complex global economy, and stocks do not have specific maturity dates as do bonds. Investors have concluded that there is no alternative to the big, dividend paying companies in stable industries such as healthcare, consumer staples, food, communications, and electric utilities. The prices of stocks in these chosen industries have risen to valuations seldom seen. The risk going forward is that a retreat of even 10 to 20% in the prices of these stocks will offset years of dividend payments. Investors who are piling into these stocks are ignoring this risk, just as investors ignored the risk of real estate in 2007, or tech stocks in 2000. When any asset becomes universally loved and highly valued, it is usually best to look elsewhere.

Given the shrinking rewards and growing risks of bonds and stocks being treated like bonds, we are starting to pivot away from these favored investments. The alternatives are cash and more economically sensitive companies. In the second quarter we began to sell off some of the holdings that have benefitted greatly from the “safe-haven” buying frenzy, and bought shares in companies that are more economically sensitive. Many of the new investments pay meaningful dividends, and have good long-term growth prospects, in our opinion.

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