July 2016

Aftermath of the Brexit

• Introduction to Brexit
• Market reaction and avoiding emotional traps
• Short and long term consequences
• How we’re protecting your investment

The market was caught flat footed when a surprise Brexit vote to leave the European Union (EU) prevailed 51.9% to 48.1% leaving the UK in turmoil. As to be expected there is a lot of speculation to what this vote means and in truth nobody knows what’s going to happen. However, when there is uncertainty the first action to happen in the market is to sell equities and move the money to lower risk assets such as treasuries. As in the past markets will first overreact and then reclaim some or all of their losses in fairly short order. In our opinion Brexit is not going to be a long term weight on the global economy and in fact only 2.9% of the S&P500 revenue actually has United Kingdom exposure.

Market Reaction and avoiding emotional traps

We want to highlight last 2 shock events to understand why we don’t allow fear in the short term change our long term financial plan.

The VIX index which measures fear in the market is now pushing close to where it was in August of 2015 after it was reported a pending China slow that would destroy global growth. This event caused the Dow to open down more than 1,000 points. The second event occurred in January/February 2016 when oil crashed due to excess supply and fear of declining global growth that would destroy demand.

FactSet Insight

chart july

Both of the crashes were devastating only if you sold out during either event because of fear. If you sold at the bottom you would have lost 11.17% in the first scenario and 10.51% in the second. Both recovered after sentiment got better to high levels in about two and a half months. This period over the course of a 20 year portfolio plan is about 1% of your investment timeline. It is a small time investment to hold through the dips and avoid large losses.

Table Morrison July

Short-term and long-term Brexit risks

In the short term other than the initial shock of the vote there is no immediate impact. The UK continues to be a full member of the EU for the next 2 years. The next step would be domestic UK legislation approving withdrawal from the EU and then a notification to the European Council giving notice that the UK has decided to leave the EU. A withdrawal agreement would then be negotiated with the EU over a two year period, or if needed (and agreed) a longer period of time. If an exit agreement isn’t reached within the two year period (or any agreed extension period), the UK would cease to be a member of the EU. This gives significant time for the market to digest the news and consequences before real change happens.

Longer term political consequences are not clearly known at this point but a major concern was the UK banking system. As stated this morning by the BoE governor, the capital requirements of the largest UK banks are now ten times higher than before the financial crisis. UK banks have risen over £130bn of capital, and now have more than £600bn of high quality liquid assets. In addition, the Bank of England has stress tested them against scenarios more severe than the country currently faces. As a result the UK banks can withstand a very extreme growth shock.

The British economic outlook is also now materially diminished, the hit to Europe is considerably smaller and the effect elsewhere in the world should be quite limited unless global financial conditions deteriorate in an outsized way in response to the vote. As stated in the introduction only 2.9% of the S&P500 revenue is derived from the UK.

The last main fear is that contagion will hit the EU and other key member’s begin to leave. The economic outcome of this will likely trigger a Europe recession and in today’s global economy would likely lead to a global recession. As of now this is still highly unlikely. In this scenario gold and short term high quality debt would be the best place to invest while riskier assets like equities, commodities and high yield debt would decline significantly.

How we’re protecting your investment

We are not reacting to the current negative market. Instead, we have transitioned our portfolios to be more resilient against market volatility by adding alternative investments over the past month. In June we added a market neutral fund and a private equity fund to our portfolios. We’re still waiting on approval to include another alternative that we’re excited about as well. This has allowed us in our opinion to de-risk in a new way that benefits you the client. We have also reduced exposure in US mutual funds that had riskier characteristics and replaced them with a strategic mix of ETF’s. The ETF’s have significantly lower fees and 100% of the savings are passed to you the client. We are continually looking to improve performance with our clients in mind.

FactSet Charts – CBOE Volatility Index
Return data and chart data below taken from FactSet

This newsletter was prepared solely by Bruce Morrison who is a registered representative of HollisWealth™ (a division of Scotia Capital Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada). The view and opinions, including any recommendations, expressed in newsletter are those of Bruce Morrison only and not those of HollisWealth. TM Trademark of The Bank of Nova Scotia, used under license. Morrison & Partners Wealth Strategies is a personal trade name of Bruce Morrison.