Market Commentary

The British are leaving! The British are leaving!

July 2016

"I know we’re talking politics here but it can’t be a disqualification to know what you’re talking about.”
- Tony Blair

"The stock market is a device for transferring money from the impatient to the patient"
– Warren Buffet

We hope everyone enjoyed their 4th of July weekend. As we return to work following the celebration of the 240th anniversary of the U.S. Declaration of Independence from Great Britain, it is somewhat ironic that the market has been anxiously fixated on the United Kingdom’s June 23rd referendum to declare its ‘independence’ from the European Union.

Following the referendum -- commonly referred to as ‘Brexit’ -- the global stock markets fell by roughly 5% over two dramatic days, and then recovered all of those losses as cooler heads prevailed over the next 3 days. In our view this brings two things into focus: First, the UK and Europe face a long road of negotiations and uncertainty around this historic decision by UK voters. Second, an important reminder that investors and the broad market will always be faced with some type of newsworthy crisis, usually overreacting at first, and the best course of action is to stay invested in good companies for long-term growth. As we said in our initial note, keep calm and carry on.

Estimates of the economic impact resulting from the ‘Leave’ vote vary dramatically. This makes any kind of forecast at this point bewilderingly complex and a rough guess at best, despite the conviction you might read from financial pundits about the certain unraveling of Europe. Uncertainty rules the day right now. We do know that this uncertainty will likely make it harder for businesses to commit capital until there is some resolution on the free trade agreements that the UK currently enjoys. On a call discussing the implication of the Brexit vote, former Prime Minister Tony Blair pointed out that Britain will find itself in the odd position of negotiating itself out of a whole lot of things and then back in to those same things.

Unlike the Lehman collapse in 2008, which was a market-driven event, that had an economic impact resulting in a political response; this is a political event that will have uncertain economic implication that resulted in a market response. This is an important difference and the market seems to understand that so far.

But what does all of this mean from the perspective of the U.S. investor? Taking a step back from the political uncertainty, the domestic economy seems reasonably healthy. The latest forecast of U.S. real GDP growth¹ from the Atlanta Fed is 2.7% annualized in the second quarter. This would represent acceleration from the first quarter reading of 1.1%, which was revised higher last week. The current 4.7% unemployment reading is the lowest since November 2007. Housing starts are running ahead of completions, which we view as generally positive for construction demand. We are also encouraged by our rather informal San Francisco Construction Crane Index, which is really just an observation of the number of construction cranes in S.F. and the East Bay skyline.

Historically low interest rates, which we talked about in our commentary last quarter, still present a real challenge and risk for U.S. investors and businesses. This added degree of global economic uncertainty from the UK will likely keep the Fed on hold, thus extending the current environment. Feedback that we have gotten from fund managers echoes our view that the initial Brexit reaction was overblown and the more troubling long-term concerns are stubbornly high valuations and dangerously high levels of debt fueled by low interest rates.

The Brexit volatility erased the low single digit gains that had accumulated in the S&P 500 leading up to the vote, however the market bounced back right before the quarter ended. Large Cap stocks are now up 2.7% through the first half of the year. Small Cap and Mid Cap equities are doing better, up 5.5% and 7.0%, respectively, and are less sensitive to dollar strength than large cap multinationals.

So what are the lessons from the British referendum and our outlook for the remainder of the year and beyond? As we have said many times before; stay disciplined and stay diversified. Having an investment discipline and sticking with it is a foundation for success. Uncertainty creates opportunity. Since we are back where we started for the year, many of the market challenges remain: overly accommodative interest rate policy is distorting assets prices and the path to a more a normal environment remains murky. The only sensible investment prescription then is to diversify across asset classes to help minimize risk.

It is said that markets climb a wall-of-worry and this market is no different. No doubt, the British referendum and the impact that it has on the UK and EU markets and economies will continue to unfold. Soon we will turn our attention to our own election, and then to the Fed, and then to the next eventual macro or political shock to the market. We’ll do our best to stay patient and guide your portfolios forward through this and any future uncertain economic landscape.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

1. https://www.frbatlanta.org/cqer/research/gdpnow.aspx