The most significant event of the second quarter, the economic confusion caused by the Brexit vote, occurred right at the end. The United Kingdom’s decision to withdraw from the European Union, after 43 years of membership, caught many investors by surprise, judging by the quarter’s strong run up in stock prices, even though political observers thought a Brexit vote was a real possibility. The S&P 500 saw a drop of 600 points in 1 day and a total loss of 5.4% in 2 days, erasing 2016 gains, before partially rebounding. It is interesting how one day can change investor sentiment from ‘hope for the best’ to ‘plan for the worst’. Brexit was compared to financial crises of the past such as the Lehman Brothers bankruptcy of 2008, which set the stage for the Great Recession, and the European debt crises of 2010. These comparisons are unfair because the past events had an immediate economic impact that triggered an unavoidable chain of terrible events. This is not the case now.
It was clear that a vote for Brexit would be a major international event but the impact it had on the US stock market was somewhat surprising. The initial reaction to Brexit, as with most global events, was an overreaction. Many investors may have feared a repeat of the eurozone sovereign crisis. High equity valuations and an upcoming earnings season are the likely reason, though. The Brexit vote coincided with negative earnings pre-announcements and spooked investors all too willing to sell coupled by corporations being unable to buy their stocks due to a blackout period in earnings season.
Although market uncertainty will be elevated for some time, the overall economic impact of Brexit should have a minimal impact on the US. Here are some reasons why. The US economy is strong and accounts for 69% of S&P 500 sales so the focus should be more on the US consumer than the British voter. Retail sales figures for April and May 2016 show a regained strength in US consumer spending. US jobs are secure and wages are rising. Great Britain only accounts for 4% of the global economy. Also, there will be a 2 year period for the UK to negotiate its EU exit strategy, and time for stabilization.
Divorce negotiations between Great Britain and the European Union will be closely watched by market pundits and investors and hopefully, the focus will be on economic growth and relationship building rather than austerity measures and populism. Although there is uncertainty now and concerns of a Eurozone crisis, as time moves on, it is likely that everyone involved will adjust: the EU, the UK and the US…who has close ties to both. One result of Brexit and recent market volatility is a recalibration of interest rate expectations, as a hold or cut in rates is now seen as more likely than a raise. Again.
A lesson to ponder is that it is wise to be conservative ahead of unpredictable political events. The Brexit vote and the Leave and Remain campaigns that preceded it in Great Britain call to mind our upcoming presidential election, which will pit two unpopular candidates against one another. Polls on the day of the Brexit vote pointed to a Remain victory, just as Clinton has 70% odds on winning in November, according to PredictIt.com. Are we transitioning to a period where politics is more important than economics in world markets? Regardless, a diversified portfolio that is appropriate in terms of risk tolerance and time horizon should be adhered to, rather than letting recent news steer your investment decisions.
Olivia A. Mussett, CFP®