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Special Report - Released 6/24/16

  • Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
  • Jeff Clark, CFA, CFP®Manager, Investments & Wealth Management
  • Kent Anderson, CFA - Senior Investment Officer
  • Andy Finks, CFA - Investment Officer
  • Todd Bunton, CFA - Investment Officer
  • Chelsie Moore, CFA, CFP®Investment Analyst
  • Jonathan Strok, CFA - Investment Associate 
Key Points
  • The UK has voted to leave the European Union, jolting global financial markets
  • We believe this news is a bigger deal for the UK and EU than the US, whose economy remains relatively well-insulated
  • As with other recent headline-driven selloffs, we do not advocate investors abandon their long-term strategies
What Happened

The United Kingdom held a referendum Thursday on whether or not to remain a part of the European Union, an economic and political bloc of 28 European nations. Despite early polling suggesting it would remain, Britons voted in favor of leaving the EU by a margin of 52% to 48%.

Britain’s “declaration of independence” will restore some sovereignty to the UK, a key argument for those in the ‘Brexit’ camp. But it also comes at a cost, setting off a lengthy and potentially messy disentanglement from the EU, including renegotiations of trade terms. British Prime Minister David Cameron also announced his resignation as a result of the vote and will step down in October.

The Brexit news jolted financial markets around the globe on Friday. The British pound fell to its lowest level in three decades versus the U.S. dollar. Equity markets sold off heavily, particularly in Europe with the STOXX® Europe 600 falling more than 7% for the day (Figure 1).

Here at home, the S&P 500® was down around 3% around mid-day. Investors fled to the safety of high quality bonds as the yield on the 10-year Treasury note touched a near-record low of 1.42% before recovering a bit.

 

What We Think

We believe that the reaction in global markets is indicative of a combination of 1) surprise at the outcome and 2) uncertainty around the economic and market implications. Financial markets had been betting that UK voters would prefer not to disrupt the status quo. Apparently that wasn’t the case. A Brexit also creates a lot of global economic uncertainty – something financial markets despise.

While we agree that the impact on the global economy is unclear at this point, we believe that Britain’s planned exit has significantly greater repercussions for European markets than our own. The implications for the US economy should be relatively minor as the United Kingdom is simply not a major export market for the United States. It is also important to note that while the UK was a member of the European Union, it never joined the smaller eurozone, thereby maintaining its own independent currency. This at least makes the divorce a little less messy. However, the UK could still very well see businesses leave, thereby raising the unemployment rate and increasing the odds of a recession there.

There is also greater uncertainty now about the potential survival of the European Union itself. Britain’s decision to leave could embolden further disintegration efforts across the European Union. However, we see a possible silver lining in that Britain’s planned exit could trigger a focus on much needed reforms within the European Union. We think it is too early to tell if this is the end of the EU or the strengthening of it.

High quality bonds are rallying amid a flight to safety.
What it Means for Investors

Earlier this year, we had stated that we continue to expect heightened volatility in the stock market in 2016 with muted overall returns. Given the economic and political uncertainty surrounding today’s news, we do not see this “violently flat” market ending anytime soon either. Britain’s planned exit from the EU could also strengthen the US dollar relative to the pound and euro, thus squeezing corporate profits.

As for fixed income securities, today’s news once again highlights the safety characteristics of high quality bonds as both Treasuries and investment grade corporate bonds are rallying (Figure 2). We expect interest rates to remain “lower for longer” as investors continue to seek safety. The Brexit move is also expected to push out rate hikes from the Federal Reserve even further.

Over the past few years, we have seen the markets react similarly to other macro-headlines, including the Greek debt crisis, the US debt downgrade, the Fed taper tantrum, and China. In each case, the initial selloffs turned out to be an overreaction. Time will tell whether or not this time is different. However, we do not view today’s Brexit news as a “2008 Lehman Brothers” type event and do not advocate investors abandon their long-term strategies.

Definitions
The S&P 500® Index is an unmanaged index that contains securities typically selected by growth managers as being representative of the U.S. stock market.

The FTSE 100 Index comprises the 100 most highly capitalized blue chip companies listed on London Stock Exchange.

STOXX® Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

The Nikkei 225 index is a price-weighted equity index, which consists of 225 stocks in the 1st section of the Tokyo Stock Exchange.

Chart data comes from Thomson Reuters Datastream a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis

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Past performance does not guarantee future results. All investing involves risk, including risk of loss.

All information is as of the report date unless otherwise noted.

All indexes are unmanaged and returns do not include fees and expenses associated with investing in securities. It is not possible to invest directly in an index.

This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.

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