Yesterday's vote by the British electorate to end its 43-year membership in the European Union seems to have taken just about everybody by surprise, but the aftermath could not have been more predictable. The uncertainty of how, exactly, Europe and Britain will manage a complex divorce over the coming decade sent global markets reeling. London's blue chip index, the Financial Times Stock Exchange 100, lost 4.4% of its value in one day, while Germany's DAX market lost more than 7%. The British pound sterling has been crushed (down 14% against the yen, 10% against the dollar).
Compared to the global markets, the reaction among traders on U.S. exchanges seems muted; down roughly 3.5% at the close, though nobody knows if that's the extent of the fall or just the beginning.
The important thing to understand is that the current market disruptions represent an emotional roller coaster; an immediate panic reaction to what is likely to be a very long-term, drawn out accommodation between the UK and Europe. Given these circumstances it is probably premature to assume that German companies are 7% less valuable today than they were before the vote, or that the pound sterling has suddenly become a second-rate currency. When the dust finally settles, people may well find that this panicky Brexit aftermath was a buying opportunity, rather than a time to sell. Those who sold may come to realize they were suckered once again by panic masquerading as an assessment of real damage to the companies they were invested in.
What happens next for Britain and its former partners on the continent? Let's start with what will NOT happen. Unlike other European nations, Britain will not have to start printing a new currency. When the UK entered the EU, it chose to retain the British pound—that that, of course, will continue. Stores and businesses will continue accepting euros.
On the trade and regulatory side, the actual split is still years away. One of the things you might not be hearing in the breathless coverage in the press is that the British electorate's vote is actually not legally binding. It will not be unless and until the British government formally notifies the European Union of its intention to leave under Article 50 of the Treaty of Lisbon—known as the "exit clause." If that happens, Article 50 sets forth a two-year period of negotiations, subject to extension, between the exiting country and the remaining union. Since British Prime Minister David Cameron has officially resigned his post and called for a new election, that clock probably won't start ticking until the British people decide on their next leader.
After notification, attorneys in Whitehall and Brussels would begin negotiating, piece by piece, a new trade relationship, including tariffs, how open the UK borders will be for travel, and a variety of hot button immigration issues. Estimates vary, but nobody seems to think the process will take less than five years to complete, and current arrangements will stay in place until new ones are agreed upon. So, for the foreseeable future, despite what you read, the UK is still part of the Eurozone.
So, how should investment clients of Gasber Financial Advisors, Inc. respond to Thursday's events and subsequent market reactions? For an answer we turned to Dimensional Fund Advisors, our long term partner in managing client portfolios.
"While there has been much speculation leading up to and since the vote, many of the longer-term implications of the referendum remain unclear, as the process for negotiating what a UK exit may look like are just beginning.
Dimensional has nearly 35 years of experience managing portfolios, including during periods of uncertainty and heightened volatility. We monitor market events—including their impact on trading and trade settlement—very closely and consider the implications of new information as it comes to light. We are paying close attention to market mechanisms and they appear to be functioning well. Our investment philosophy and process have withstood many trying times and we remain committed.
We urge caution in allowing market movements to impact long-term asset allocation. Long-term investors recognize that risks and uncertainty are ever present in markets. A drop in prices is generally due to lower expectations of cash flows, higher discount rates, or both. In some cases, a drop is also due to investors demanding liquidity. In the current situation, some investors and economists may expect lower cash flows due to possible trade barriers that may not be implemented [Emphasis added]. Higher discount rates may be occurring due to uncertainty about changes in the economic landscape and regulations. We have seen markets increase discount rates in times of uncertainty before, resulting in lower prices and increased expected returns. However, it is difficult to know when good outcomes will materialize in the future. By attempting to time the right moment to invest or redeem, one risks not enjoying the potential benefits of such materializations. Many of those who exit the markets miss the recoveries [Emphasis added]. What we have often seen in the past is that investors who remained in well-diversified portfolios were rewarded over time.
The UK will have up to two years to negotiate a withdrawal, during which time it remains subject to EU treaties and laws. Any potential operational changes depend on what path the UK and EU decide to take. Leading up to and since the vote, we have worked with our counterparties, including custodians, brokers, and dealers, regarding potential operational implications resulting from the UK's leaving the EU.
Dimensional remains committed to helping our clients in the UK, other parts of Europe, and around the world have a good investment experience. "
In conclusion, the important thing for everybody to remember is that many market participants are being driven by fear due to uncertainty and predictions based on incomplete data. What is being described by many in the media as an event is really a long process. Nobody knows exactly how the long-term prospects of Britain, the EU or American companies doing business across the Atlantic will be impacted by Brexit, but it would be unwise to assume the worst so quickly after the vote.
"The difficulty first in predicting events, but even the greater challenge of predicting how other investors will react to these events. The most reliable way for investors to accumulate and preserve wealth is to adopt and maintain a broadly diversified strategy. Diversified across companies, across industries, across countries, and across currencies. This idea that we should dip and dart and reduce our exposure to risky assets based on some prediction that we our others might make more often than not lead to frustration and failure to capture the rates of return that capital markets have to offer."
- Weston Wellington, Vice President, Dimensional
- From: The Financial Crisis in Greece at https://www.dimensional.com/v/?v=1_rustqjut&p=b10a130d-eaed-4b90-a69a-882bf2c3cf15&f=false&d=true
"Europe, the U.K., the U.S. and the rest of the world will adapt to the new reality. As for the markets, they discount the future and will absorb and reflect the implications of Brexit relatively quickly. So it's best not to extrapolate what happens today or next week very far into the future. In the end, broad diversification coupled with adequate cash and bond reserves will carry us through any short-term dislocation we may observe as a result of Brexiting Brits."
- Dave Yeske, Managing Partner of Yeske Buie, Inc.
"Each year investors end up getting a variety of curveballs tossed their way. Last year it was China, the year before Greece and this year Brexit. While this may permanently impact the Brits in many ways, a few years from now it will merely be a footnote in stock market history."
- Brent R. Brodeski, CEO of Savant Capital Management