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Goodbye England

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England says goodbye to Europe.

Photo courtesy of express.co.uk

A panic rush for the exit door of a burning theater is likely to end up with people trampled to death. That’s why in such situations people are told to “remain calm.”

However, the second advice is to “find an exit near you.” If the theater is indeed going up in flames, it is a very bad idea to remain inside for no other reason than to show that you are unswayed by the surrounding frenzy.

That, in a nutshell, is the dilemma that Brexit, or last week’s decision made by the UK to leave the European Union, poses to investors. Stripped to its essence, the question is whether Brexit is about to set world markets aflame or whether it is just a lot of smoke.

Some would undoubtedly run for the exit before calmly reflecting on the question, just in case that by the time they reach an answer they find that it’s too late. Those are the ones that pundits often scorn – the ones easily scared, who liquidate positions at the first sign of trouble. But, given how much people suffered through the financial crisis of 2008, it may be unfair to paint them as undiscerning lemmings. The rational response, especially for those who depend on their portfolios for retirement, may well be to choose a certain outcome (known losses) over an uncertain one (far larger losses down the road). After all, portfolios subject to periodic withdrawals to fund living expenses can’t recover well in a falling market.

So will Brexit trigger larger losses down the road? The market seems to think the vote was bad enough to send the British pound tumbling to its lowest level in decades, and the foreign exchange market is not one dominated by small-time retirees but by very large professional traders. So is the bond market, which is in an increasing state of disarray as many developed-market government bonds are trading at even deeper negative interest rates (which means that not only you won’t receive any interest from buying a German bond, for example, but that you would pay the German government for that privilege).

But stock markets seem unfazed. Implied volatility of the US stock market (the VIX) spiked temporarily as people rushed to buy insurance, but quickly dropped back to non-crisis levels, suggesting that the equity market is not really worried about Brexit. While there are many weaknesses that have been so far been glossed over (decreasing earnings, higher dependence on corporate buybacks, a slowing economy, an explosion of private-sector debt, etc.), Brexit may not be the catalyst that would bring the market down to levels that reflect those concerns more fully. As long as the Fed and the ECB continue to keep rates down, the market seems to think everything will be OK. Indeed, according to Factset, corporate stock buybacks are at record highs. As long as money is dirt-cheap, this built-in demand for stocks is likely to continue.

More worrisome is the idea that the British vote gave a shot in the arm to similar anti-European forces. The more vocal ones in France, Austria and the Netherlands have already called for a similar referendum.

To be sure, it is exceedingly unlikely that any other EU member would allow such a vote, as it is now quite clear that UK Prime Minister David Cameron made an enormous mistake in doing so, not only because it triggered huge market and political uncertainty, but also because it cost his job and possibly condemned him go down in history books as the man who divorced the UK from Europe.

The reasons for the vote result have been discussed at length everywhere and we will not rehash them here. With respect to the market impact, our initial assessment is that it is difficult to see how this could be seen as a positive, or even neutral, market event. As we see it, the only way for all this to blow over is for the UK Parliament to ignore the vote – which they can do, since the referendum is not binding. Barring that, increased uncertainty over the future of Europe seems likely to keep in place the going-nowhere, up-and-down market state that has ruled for the last two years. The tug-of-war between deteriorating fundamentals and distorting cheap money is likely to keep stocks range-bound at best.

There may be some positive outcomes for continental Europe in the long term, however. Multinational companies that were domiciled in the UK to gain entry into the EU could change address to a safer location within Europe, for example. While regulations in the UK are friendlier than in Italy, France or Germany, they hardly compensate for the large loss in market access that corporations are now facing. This would provide a boost to European economic activity.

Furthermore, while popular discontent with elites, globalization, technological advances and immigration has finally exacted its first victim, one can be grateful that it was the UK (who is relatively small and always had one foot outside of Europe anyway) and not Germany or France, which would have been the end of the Eurozone and triggered all-out chaos. If European authorities take due notice of what has happened and the danger of ignoring the complaints of their people, Europe may well emerge stronger by this vote.

This is a big if. But it is perhaps possible that the UK may prove to be the sacrificial lamb that ended up making Europe stronger. Such outcome would not become clear for many months, or years. For now, however, chances are that volatility and uncertainty will set in. This is when sensible investment plans that take risk control seriously are most needed. While panicking is never recommended, a sober assessment of risks is necessary to make sure that investment portfolios can still grow while not exposed to unnecessary dangers.

What now?

Our clients want to make sure that their investments are managed efficiently and prudently, and that they partner with an advisor who helps them cut through the market noise. We look at their specific situations and use quantitative techniques and solid execution expertise to build and maintain investment portfolios that are suitable for their needs. We try to identify when to buy or sell different asset classes, with a focus on controlling downside, seeing through the haze of short-term volatility, and looking at what securities are priced favorably at various times. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more