In the second quarter of 2016, Great Britain’s so-called “Brexit” vote, a national referendum on continued participation in the European Union, sparked an abrupt bout of global market volatility in June. Equities across the globe slumped after the Brits surprised the world by voting to leave the EU, some by double digits. In a matter of days, this market turmoil disappeared as quickly as it came and most markets ended the quarter in positive territory.
For the quarter, large company US stocks, as measured by the S&P 500 were up 2.46%, while the small cap Russell 2000 ended up 3.79%. Overseas developed markets had farther to recover after the Brexit vote, but regained most of the June downturn with the MSCI EAFE finishing down 1.19%. Emerging markets managed a slight gain with MSCI Emerging Markets index up .80%. Bonds had another positive quarter as evidenced by the Barclays US Aggregate up 2.21%, once again defying those challenging the wisdom of holding fixed income.
It seemed like yesterday when we dedicated an entire commentary to the European Union and the eurozone (EU members that also share a common currency), but it was actually in 2011. At the time, markets were reacting to a combination of dilemmas challenging the very essence of the 16-year-old experiment of a common currency known as the euro and the viability of the entire union. Now that Britain’s vote has called attention to these matters again, we thought it would be useful to remind our readers of the role the EU and the eurozone play on the global stage and what the future might hold for both Britain and the EU post Brexit.
Most Americans have a limited understanding of all the moving parts in European monetary and fiscal systems, which is unfortunate given the important role Europe plays in the global economic landscape. A complete explanation of these entities is far beyond the scope of this letter, but we will provide you with a basic understanding of the EU, its interrelationship with the eurozone and the context in which the British made their decision to leave the Union.
The European Union (EU) is a partnership where member states cooperate on a wide range of economic, social and political issues. The concept of this union began after World War II, initially by six Western European countries – Belgium, France, Germany, Italy, the Netherlands and Luxembourg, with the intent to promote peace, security and economic development. Over time, membership in the union has grown to 28 member states sharing markets with coordinated trade policies. As this partnership developed, the desire for more integration has taken shape with 22 of the EU members agreeing to free movement between member states without passports (the Schengen agreement) and 19 member states sharing a common currency (the eurozone). In addition, the EU has a whole host of treaties and agreements with regard to foreign and security policies to help unify the union, many with roots in fostering peace and prosperity after World War II.
The European Union has multiple governing bodies that oversee different aspects of its operations. Brussels is the de facto capital of the union and is the site of much of the official business of the EU. The European Commission is the executive body of the EU and is responsible for proposing legislation, implementing decisions, upholding the Union’s treaties and the general day-to-day running of the Union. The European Council, made up of member states, enforces legislation throughout the union and seeks to improve cooperation between governments. The Council is the more powerful of the two and the one that dictates most of the important decisions. Within this council is a subset made up of the original six members, referred to as the “EU-6”, which tends to rule the roost on most matters. In addition to these governing bodies, the European Parliament serves as a public forum of the EU debating important issues and overseeing the activities of the Council and Commission.
There is general consensus that the European Union has been a success story for greater Europe having provided political stability and economic prosperity. If you include Great Britain, the EU is the largest single trading block in the world and the largest trading partner of both the US and China. However, the Union and the eurozone have and will continue to face myriad challenges both economically and politically, as evidenced by Britain’s decision to leave the union. This is a significant event, as Great Britain is the first country to vote to leave the EU. While Algeria (1962) and Greenland (1985) both voted to leave, technically, they left the EU predecessor, the European Economic Community (EEC). The Great Britain referendum turnout was 71.8%, with more than 30 million people voting, making it the highest turnout in a UK-wide vote since the 1992 general election. That said, the vote was 52%-48%, leaving the country almost equally divided on the issues surrounding the decision to leave.
The root cause of contention in this union is the difficulty in trying to become a true single market while maintaining some semblance of economic and political sovereignty. As the EU has developed, there have been various degrees of commitment to its broad ideals. Some members support a more loose association, yet others seek a far more integrated, unified union. While they all recognize the value of the union, these differences in member states become abundantly apparent in times of economic or political duress.
Economically, eurozone-related issues seem to be ground zero for this contention. Before the launch of the euro in 1999, world-renowned economist and Nobel laureate, Milton Friedman encouraged the eurozone to abandon the idea of a single currency platform. If they chose to proceed, he predicted that the eurozone would not survive its first major economic crisis. Friedman recognized what may prove to be a fatal flaw of eurozone, which is, without flexible exchange rates of currency, imbalances will be created as individual member states have limited mechanisms to deal with their own economic cycles.
The problem arises because each member state has full control of fiscal decisions such as tax rates, entitlements, and government spending. In addition, they each have differing societal views on saving, consumption and work ethic. Collectively, these dynamics have consequences that create differing economic outcomes and cause imbalances between members with no monetary means to balance them. For instance, low workplace productivity, unrealistic entitlements, and lax tax enforcement in Greece have resulted in skyrocketing deficits and stifling debt that has placed it on the brink of insolvency. Germany, on the other hand, has far tighter fiscal controls, a more robust economic infrastructure, high personal savings and is able to take advantage of an artificially low currency. If Germany had its own currency, it could not be as competitive globally, because its currency would rise in value. Germany is helped and Greece is hurt by sharing the same currency. As these imbalances arise, it tears at the fabric of the union and causes countries like the UK to question its union bonds.
Politically, it has been equally challenging to form political bonds with countries that at times have been bitter enemies. Further, no member state wants to relinquish its sovereignty to Brussels or any other governing body. Over time, there has been a notable rise in support of populist, nationalist, anti-establishment political sentiment across the EU, not unlike some of the rhetoric coming from US politicians of late. The combination of economic woes stemming from the financial crisis in 2008, structural and social dynamics, and the recent wave of disruptive migration from the Middle East and Africa have empowered so called “euroskeptics” to push for less control from Brussels and more self-determination in each member state. The UK’s decision to leave the union was influenced by both economic and political dynamics, but in the end proponents of Brexit focused on self-determination, especially with regard to migration, outnumbered those voting to remain.
To give you an idea of the complexity of this matter, consider the following list of issues that remain whether Britain voted to Brexit or Remain:
As you can see, the EU has a lot of work to do in reforming itself for sustainability. Perhaps the Brexit will be the catalyst for positive change.
While the UK has officially voted to leave the EU, nothing will really happen until they trigger Article 50 of the Treaty of Lisbon, which establishes the protocol to disengage from the EU. Pundits estimate that once this is triggered, it will take two years to complete. In the meantime, leaders in the EU are divided between those who want to punish the UK as a warning to others who might consider the same path and those who want to reform the union to be a more viable and cohesive entity. We mentioned the EU-6, a powerful subset of the governing body of the EU. Shortly after the Brexit vote, they made the following statement in response to the vote which hints to a more sympathetic EU on Brexit:
It is to that end that we shall also recognize different levels of ambition amongst Member States when it comes to the project of European integration. While not stepping back from what we have achieved, we have to find better ways of dealing with these different levels of ambition so as to ensure that Europe delivers better on the expectations of all European citizens.
History has shown that it is impossible to predict the magnitude and timing of market reactions to economic and political events, underscoring the long-term benefit of diversification.
Over the last five years, large company US stocks and investment grade bonds have been bright spots of global markets as the Federal Reserve embarked on massive monetary stimulus and structural reform. Global investors responded by pouring money into the US markets as a safe haven. As a result of capital inflows, US stock valuations and comparative market performance have become stretched relative to their global peers and a rebound in the opposite direction appears inevitable. The current levels of relative valuation have occurred several times over the past 50 years and each time it begs the question, Why diversify?. We don’t know when this will peak, but a study of history demonstrates it is at these times when diversification has proven its greatest value. Global investors will seek out the most favorable risk/reward opportunities, and as the US markets are expensive relative to other markets, money will flow out and other markets will become the performance leaders. There is no doubt that challenges in the Eurozone have played a role in holding back the performance of their markets, but those same challenges bring about change that unlocks the value.
As global economic and political events unfold, there is a tendency to believe that events can be foreseen or their impact can be accurately predicted. Academic research clearly debunks this belief, yet demonstrates that they do offer opportunity. Our disciplined long-term investment methodology takes advantage of these performance divergences by measuring risk-adjusted returns and the behavior of each asset class relative to the others to maximize return while reducing volatility over time.