Capital Advantage, Inc. on Brexit

As most of you are likely aware, the United Kingdom (UK) delivered a shock to global markets today by voting via referendum to leave the European Union (EU). The EU’s formation helped to facilitate trade and commerce among Western Europe, and the UK’s departure could likely result in less favorable trade agreements between the UK and EU.  Once the UK starts the exit process, they will have a period of two years to renegotiate trade agreements with the EU– though the negotiation window can be extended indefinitely. It is worth noting that the UK vote to exit the EU (Brexit) was an advisory vote, and is not legally binding.

In response to the Brexit vote, global equity markets adjusted negatively around the world. The US experienced an approximate equity market decline of 3.5%, while European markets declined roughly 11%. Prior to the vote, most polls and observers had shown that the UK was likely to remain in the EU, and therefore markets closed Thursday up roughly 3% on a sizable ‘relief rally.’ The sell-off today is likely a knee-jerk reaction to a surprise event; understandable, since markets generally overreact to negative geopolitical news. A study by Ned Davis Research on 51 geopolitical crises of the 20th century found that on average, across all 51 crises, the Dow Jones Industrial Average index was higher 6 months prior to sell-offs, and 6.3% higher one year later.

As you may recall from our most recent newsletter, we have already reduced US equity exposure this quarter (moving proceeds to fixed income), concurrently shifting from growth to value/dividend equities. Fixed income is one of the few asset classes that, in general, performed positively today, representing a prime example of the “downside protection” fixed income can offer to a diversified a portfolio.

Due to today’s vote and to the likely oversold conditions we did not reduce international equity exposure and therefore reducing the likely hood of locking in any short-term losses. However, given that today’s events appear to point to a future of diminished free trade—and therefore lower economic growth for both the UK and the EU as a whole—we are likely to look to reduce exposure to international equities in the near future. We will await further information and allow markets to stabilize prior to making investment changes.

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