What happened?

1.  The U.K. electorate voted 52% to 48% to exit the European Union after more than four decades.  Although polls had shown the vote to be neck-in-neck, the markets had started pricing in a favorable outcome (remain) with world markets rallying ~4% over the last week and the GBP/USD trading up to 1.50 from a mid-month low of 1.41.

2.  The fallout from the vote is ongoing but these are the developments so far (as of 9:00 AM EST):

    • The GBP/USD plunged 11% to 1.31 (the lowest since 1985) before settling back to 1.38.
    • Prime Minister David Cameron resigned and would serve another three months.  Brexit campaign leader and former London mayor Boris Johnson is the current frontrunner to take over Tory leadership. 
    • The immediate economic fallout is not known but it will likely impact the London financial sector as global banks such as JPMorgan Chase and HSBC Holdings argued that a Brexit vote would result in thousands of jobs leaving London for other European locales such as Ireland.  Financial services employ 2 million in Britain.
    • The exit is not immediate but would call for Britain to invoke Article 50 of the Lisbon Treaty which calls for a two-year process to negotiate the withdrawal.  This is where the market hates uncertainty because it is unclear to what extent the London financial sector will be able to distribute financial products and services across the European bloc.  In addition, Germany and France will likely take a strong stance in the initial round of negotiations to send a warning to other EU members who are also facing populist pressures to leave the union. 
    • Why was the referendum called for in the first place?  This was a gamble by Tory leader David Cameron to appease the faction of conservatives who were threatening to bolt to the UK Independent Party (the leading anti-Euro skeptic movement).  To ensure a successful 2015 election outcome, Cameron made a commitment to allow for a referendum, a gamble that has now failed in hindsight.
    • Despite the tough posturing taken by Germany and France, this outcome will likely embolden other populist movements, notably in France, the Netherlands, and Italy.  Populism introduces an element of uncertainty.

3.  Market reaction so far has been clearly negative.  European stocks dropped 9%, the UK was down 4.5%, oil was down 5%, Japan was down 8%, and US futures are pointing to a 4% drop.  Safe haven assets such as gold, US Treasuries, the Japanese yen have soared following the outcome.  

Looking Past the Near-Term Fallout

  • The main concern is what knock-on (domino) effects Brexit will have on the financial markets.  UK banks have dropped over 20%, European banks are down 8-9%, and U.S. banks look to trade down 5%. 
  • The coming trading days will likely see more volatility due to the macro positioning taken by large institutional investors such as hedge funds.  The concern is that such giant swings can overwhelm positions leading to liquidity-driven unwinding that would only induce more volatility. 
  • However, the so-called fear gauge (VIX – or the implied volatility priced into S&P options) has only spiked to the mid-20s, far below the 40-50 level seen during the Lehman collapse in 2008 or Long-Term Capital in 1998.  This is definitely a measure to keep an eye on where further rises to 40-50 or beyond will reflect market panic. 
  • One strategist’s take, Barry Bannister from Stifel Financial, believes that the fallout from the vote will finally push politicians to address populist anxiety through fiscal stimulus measures that could prove to be reflationary in 2017-2018.  Here is a link to his presentation.  Post the 2008 financial crisis, Western governments have primarily relied on monetary stimulus via competitive devaluations and quantitative easing that has mainly resulted in financial stimulus but not translating into main street benefits.  Now that central bank measures have been largely exhausted (no U.S. rate hikes are being priced for the remainder of the year), it’s up to fiscal measures (via infrastructure and defense spending) to pick up the slacks. 

3D ETF-Managed Portfolio Positioning

  • We expect 3D Managed Portfolios to be volatile with the markets as we did not position the portfolios for a specific outcome.  There is little we could have done given our mandates and investment policy statements to position the portfolios for a Brexit as it would have meant going into cash and gold (or from a sector standpoint allocating the entire portfolio to low volatility, interest sensitive sectors such as utilities and telecoms).
  • We remain committed to global diversification but expect to be hurt at the margin by our overweight to international value stocks and smaller caps.  We expect these procyclical positions to be offset by exposure to global REITs which have proven to be a strong diversifier to equity risk during periods of uncertainty as well as exposure to more defensive factors in the U.S. such as quality and low volatility. 
  • In fixed income, our income-oriented ETFs such as senior bank loans and preferreds will likely underperform given concerns over how this vote will impact the global financial sector.  If these concerns morph into panic-driven selling, then we may opportunistically shift more capital to these ETFs since they are primarily invested in U.S. issues with little to no exposure to Europe.   

Below you can read some of the talking points 3D has prepared for advisors speaking with clients today.

  • This is not the time to engage in emotional-driven selling. If you’ve set up investment programs containing market risk with 10-year or beyond time horizons, then the programs are designed to ride out the kind of near-term volatility that we’re seeing following the Brexit vote.
  • For 3D to have positioned for a specific outcome (i.e. Leave), we would have had to violate key investment principles such as being fully invested and globally diversified. We would have had to exit our equity position in favor of cash and precious metals or exit our international positons and concentrate our U.S. equity holdings into low volatility sectors such as utilities and telecom (and even here it’s unclear what the final reaction will be). We are committed to global diversification across regions, sectors, and even factor strategies. 
  • Should major dislocations result from the near-term volatility, then we would consider positioning the portfolio to take advantage of the dislocations, whether in equities or fixed income. However, 3D will not be trading in reaction to or in anticipation of the upcoming volatility that will drive global markets following the Brexit vote.
  • Liquidating in this environment will likely lead to poor execution and poor performance. You will also have locked in your losses and lose out on any benefits of potential recoveries once the dust has settled.