As most readers are aware, Britain voted to leave the European Union last Thursday. The immediate reaction of the “Brexit” (“British Exit” if you didn’t figure it out right away) by global markets was one of uncertainty and fear. The question on everyone’s mind: Is the UK simply the first domino to fall in a long string of exits that will mark the end of the European Union? This kind of uncertainty is driving a “risk-off” trade the last two days where money is moving out of stocks and into bonds and gold. As most media outlets are fueled by fear, we wanted to take a step back and provide some facts through a simple Q&A:
What exactly is the European Union (EU)?
The EU is an economic and political partnership of 28 European countries. This partnership has rules governing a number of things but most critically (i) trade and (ii) travel/foreign employment/immigration.
What exactly did UK citizens vote on?
The United Kingdom (England, Wales, Scotland and Northern Ireland) voted on whether or not they want to remain in the European Union (EU). The UK is not in the “Eurozone” which is a monetary union that uses the Euro as its currency. This is an important fact because it is MUCH easier to leave if you have your own currency.
Why did this vote even happen?
In 2013 in order to satisfy some of the further-right leaning members of his party and to draw votes away from other parties, David Cameron, the UK Prime Minister, decided to promise to hold a referendum on the UK’s participation in the EU. At the time the country as a whole was not asking for the vote. It was a political move that didn’t pan out as expected.
What were the primary reasons for leaving?
There is no one reason but the “leave” campaign focused on (i) negatives of immigration and (ii) the costs associated with being part of the EU such as transfer payments. In effect, this is a populist movement arising from income inequality and a shrinking middle class.
What is next for the UK?
Technically the next step for the UK is to invoke Article 50 of the Lisbon Treaty. Once this is invoked, the formal legal process starts to negotiate the withdrawal. This process is expected to take two years. In that time the UK needs to renegotiate its trade pacts, worker programs, immigration, etc. It is a massive process that requires leadership.
After David Cameron resigned as Prime Minister Friday morning, it has become uncertain who will actually lead the country through this transition. The referendum vote is not legally binding and the country needs leadership in order to embark down this path. However, no one wants to step up to the plate and actually lead that process.
What is next for Europe?
This is the biggest issue causing uncertainty. Will other countries now try to leave the EU as well? We don’t know the answer but it is important to understand that it is much harder for a country within the monetary union (“Eurozone”) using the Euro as its currency to break from the union than it will be for the UK which uses the Great British Pound (GBP). The Eurozone comprises 19 of the 28 members of the EU that use the Euro as its currency. Given it is questionable whether the UK will be able to actually achieve withdraw from the EU, it is even more questionable whether any of the other countries will be able to do it. We have our doubts.
Why did the markets react the way they did?
Uncertainty. That’s a basic answer but it’s the truth. Nobody knows what is going to happen now. People sell first and ask questions later. Worst case scenarios become likely events in people’s minds and the media begins to really latch onto the fear and promote it as fear sells TV time.
Where do we come out on this?
While we never try to bet on macro events, as they are simply too hard to call (and even harder to know what is already priced in), we certainly monitor these types of developments on an ongoing basis and think about how they will impact both our active and passively managed portfolios. Right now, there is simply not enough information to come to any firm conclusions about how this is going to impact the global economy.
We purposefully have little exposure to the UK or Europe in our actively managed portfolios and remain sidelined from adding material exposure until at least the currency volatility abates and we get some idea of how this could impact individual companies. Indirectly, we are affected by the movements in the US markets.
How does this impact companies here in the US?
The immediate impact to US companies is the result of the decline in the exchange rates of the GBP and EUR. This will result in European operations translating back into lower USD earnings, resulting in an earnings contraction for multi-national US companies doing business in Europe. On the bullish side, this likely removes the chance the Federal Reserve will raise rates again during 2016 and the strong dollar will be a tailwind to US consumers (anyone want to refinance?? Now’s the time).
How have we responded?
The good news about focusing our actively managed portfolio in the small cap space is that the majority of our portfolio does not have exposure to Europe and the selloff in the markets creates opportunities to buy more shares of businesses we like at cheaper prices. We utilize our comprehensive watchlist to identify companies that have fallen below our required purchase prices. We pick our spots to patiently acquire positions.
For companies with direct UK/European exposure, we re-evaluate our company specific valuations with changes for any European operations using lower exchange rates, and ensure we still have the margin of safety we had originally anticipated then make changes where needed.
How should you respond?
Remember this wisdom from Peter Lynch: “The real key to making money in stocks is not to get scared out of them.” Declines in markets mean you get to acquire more of corporate America at better prices, which means more gains over the course of your life.
Stay put, turn off the TV, get off Twitter, focus on the long-term, continue to aggressively save and understand that when there is blood in the streets it is a great time to be a buyer.