How Are We Breacting?

It’s not often that the feature topic of my weekly market commentary is the same for two consecutive weeks, let alone three. But when that topic develops into $3.01 trillion worth of damage to global stocks across two trading sessions, it’s worth exploring a little bit further.

Brexit was a hot topic for analysts and investors last week due to uncertainty surrounding the outcome of the extremely close vote. But when the results came in early Friday morning, Brexiters had prevailed, the decision was final, and the reactions began flooding their way into the market. It seemed that every headline carried new information to support the same theme: investors were panicking, and the global economy was headed for trouble. As I watched the results come in, there was one market indicator that really struck me. By the time the closing bell rang on Monday, the Dow had fallen 871 points since news of Brexit first hit, the lowest two-day drop since August of 2015. Hang on, time out.

Economists had spent months preparing estimates for how a Brexit would impact the greater macroeconomic environment and nearly every conclusion was negative. A decline in trade, foreign direct investment, and a weaker pound all contributed to the U.K. Treasury chief’s estimate that the U.K. economy would be 6% smaller in 2030 if it chose to leave. This event would deal one of the strongest blows to the global economy since the financial crisis. But, when the results of the vote came through, the magnitude of Brexit’s impact wasn’t even the strongest short-term shock we’ve felt in the past twelve months. That says something about the market’s reaction to short-term events.

Most experts had long been in a consensus that a Brexit would spell trouble for markets which begs the question of why several people were not positioned properly for it. Most have cited faulty polling estimates on the part of both academic polling agencies and local bookies. The day before the referendum, both had estimated the probability of a victory for the Remain camp to be approximately 76%. That represented a comfortable figure especially considering the fact that just a week earlier, Bloomberg found that the Leave camp held a 3.8% advantage with 7.9% of citizens still undecided. Jack Ablin, CIO of BMO Private Bank had this to say last week before the vote: “An exit vote would catch investors flatfooted, as most of us are relying on local betting figures to conclude that Brexit is an unlikelihood.” So when the results showed the Leave camp prevailed with nearly 52% of the vote, caught off guard was exactly what they were.

But even beyond the people who simply were not prepared for the outcome of the referendum, the Brexit shock still resulted in massive global selloffs and declining stock prices. Martin Wolf of the Financial Times provided three primary reasons for this phenomenon. They are “1) the transition effect which would come from the perception that the UK had become permanently poorer 2) the uncertainty effect which comes from unavoidable ignorance about the post-Brexit policy regime, and 3) the financial conditions effect which would work via the perception that the UK was a less appealing and riskier place in which to invest.” Of those three reasons, I find the second to be most important. The transition effect and the financial conditions effect are both grounded in perception which is subjective. The uncertainty of what lies ahead for the British economy is objective.

I was fortunate to participate in a private teleconference with former UK Prime Minister Tony Blair this week through JP Morgan Chase. The discussion touched upon a number of topics within the greater Brexit debate such as the populist undertones of the Leave camp and the evolving purpose behind the European Union. He spent most of his time talking about uncertainty, particularly as it pertained to the economic future of Great Britain. But he cautioned that we can’t begin to speculate what Great Britain will be because there is absolutely no precedent for this before. Article 50 of the Lisbon Treaty has never been invoked. That means that there are two processes that have never happened before. First, no country has ever had to go through the process of exiting out of the European Union. Second, no country that was previously a member of the European Union has ever had to renegotiate agreements with them.

Moreover, even countries that currently trade with the EU still don’t offer a good model for projections. Norway, whose largest trade partner is the EU, attributes 74.3% of all imports and exports to them. Despite Norway not being a member of the union, they are a member of the European Economic Area which means they must adhere to the four freedoms of capital, services, goods, and people. One of the pro-Brexit arguments that gained the most traction was Great Britain should have autonomy over its immigration policies. If Great Britain were to simply become a member of the EEA, they would not have that autonomy. It seems unlikely that the government would address their economic issues by compromising on this particular political issue.

Ultimately, Blair said it would be 3-5 years for the markets to sort out the complications of an independent UK mainly because it will most likely take 3-5 years for the negotiations to complete. Because of a lack of precedent in this matter, only when each individual issue is finalized, will the broader picture become clearer and the markets will correct for that. In the meantime, the drop in the past two days is a shock and if previous shocks have shown anything it’s that they tend to not disrupt long-term growth. Before Brexit, stock prices were sitting at close to all-time highs and the lows of February caused by the collapse in energy prices and concerns over Chinese economic growth were a distant memory.

Our investment philosophy at Farr, Miller, & Washington is not governed by emotional reactions to short-term events or market timing tactics. We concentrate our energy in finding high quality stocks, with little debt, which benefit from secular tailwinds that support future growth. A share price represents the accumulation of all future earnings of a particular company. When the market moves sharply on some unexpected news, it is worthwhile to take a step back and ask yourself how the news will affect the underlying earnings of your investment. If the answer is not at all, it is best to write off the developments as noise and ride through the short term volatility. I wrote two weeks ago that a Brexit will probably not be the difference between reasonable market returns and massive losses over the next decade. Despite the massive drop in the past couple of days, I still stand by that statement.