The UK is Out of the EU – Now What?

June 28th, 2016
Anybody have a job opening for a former British prime minister? We hear that David Cameron will be looking for work in October, when he will resign his position.
The prime minister clearly miscalculated by calling for a popular vote on the UK’s continued membership in the EU. In the end, fear won out over practicality, and the voters decided to leave the club. Global markets’ sharply negative reaction after the result indicates that investors had not been expecting Brexit to succeed. Why they were so confident is beyond us; we wrote a week ago that the outcome was too close to call.
We’ve said repeatedly that the markets hate uncertainty, and there’s now plenty of that to go around. But one thing that we can say with conviction is that British politics will never be the same. Both major parties are in disarray, Labour has suffered a rash of resignations by its shadow cabinet, and it’s not at all clear who will lead the Brexit negotiations—or even the UK—come October.
The future is…unknowable
Not surprisingly, there has been no shortage of dire predictions by both pundits and regular people. These include a recession in the UK that may spread to the European Continent or beyond, secession by Scotland and Northern Ireland, and a total disintegration of the EU. We’ve even seen specific estimates of how much UK and Continental GDP will decline as a result of Brexit.
Why do people never learn that these events are impossible to predict? For example, recessions are rarely recognized until they are well underway; why should Brexit suddenly make these forecasts more accurate? Disintegration of the EU? We heard that several times during the Greek debt crisis, yet Greece, which is still a mess, has all but disappeared from the news. Also arguing against that apocalyptic prediction is this Sunday’s vote in Spain, in which the pro-EU People’s party picked up additional seats in the Spanish congress.
Yes, one or more of the events listed above might happen, but at this point people are just speculating. There is also the potential for positive outcomes from Brexit, which given the market’s current mood, are likely to be a most unexpected—and pleasant—surprise. For example, the current crisis may force Europe’s leaders to revamp the EU’s structure to make it more stable and beneficial to all its members, or to abandon “austerity” and start opening their purse strings a bit more. Or, heaven forbid, to lower taxes.
This is normal behavior for markets
We are actively looking at potential winners and losers amidst the current uncertainty, and particularly at companies that may now be grossly mispriced. Don’t believe for a moment that stocks are now rationally valued, as the bulk of current selling falls into one of three categories: 1) big traders reversing positions because of the surprise Brexit outcome; 2) herd behavior—selling because others are doing so; or 3) forced liquidation of leveraged accounts. Buyers who will eventually come in to stabilize prices are calmly sitting on the sidelines waiting for the right moment to pounce on some serious bargains.
When might this occur? Like any other market prediction, guessing the exact day is a fool’s errand. But looking back over similar event-induced selling panics, most of them burn out quickly. And unlike the big down days of 2008, this one is occurring in the midst of a secular bull market, one that began in March 2009 and has seen the S&P 500 triple.[i]
Secular bull markets last a long time. The one from 1982 to 2000 was nearly 18 years, while the one from 1949 to 1966 lasted 17 years. We’re only 7 years into the current one, so it’s likely to have another decade or so to go. Keep in mind that bull markets never go straight up, and big down days are not uncommon. In the two secular bull markets mentioned, there were at least 10 days when the S&P 500 fell more than 5%[ii] (last Friday’s drop was only -3.6%).
Yes, these rapid drops are scary, and they are designed to frighten as many investors as possible into abandoning stocks. Mr. Market would like nothing better than for you to sell in panic. Yet holding on yields big rewards: the last great bull market from 1982 to 2000 saw the S&P return +1,388%[iii] (that is not a misprint).
Clearly, we don’t know how the current bull market will turn out in comparison with prior ones. But since it’s impossible to consistently time the market, we’re all better off taking the bad with the good, as uncomfortable as that may feel. Remember, if you want higher returns, you’ve got to put up with risk and occasional discomfort. If you want calm and easy, you’ll have to settle for less than 1% a year from a bank CD.
All our best,
Dr. Ken Waltzer, MD, MPH, AIF®, CFA, CFP®
Managing Director, KCS Wealth Advisory

Laura Gilman, CFP®, PFP, MBA
Managing Director, KCS Wealth Advisory

Adam Bragman, CFA
Director of Investment Research, KCS Wealth Advisory

The Brexit Vote

June 24th, 2016

Today we received the unprecedented news that the United Kingdom (U.K.) has voted to leave the European Union (EU), which had led to significant volatility in the global markets. In situations like these, it becomes more important than ever to remain calm, harness our emotions, and stay committed to our long-term plans. Although this result was unexpected, as your financial advisors, we are here to offer continued support and guidance through these challenging market events.

Yesterday, June 23, the United Kingdom (the U.K., comprised of England, Scotland, Northern Ireland, and Wales) undertook an all-country referendum about whether the U.K. should stay in or exit the EU, which it has been a member of since 1975. This vote, referred to as the “Brexit” vote, is done by allowing all citizens to cast their ballot on whether to “remain” or “leave.” In a very close vote, “leave” brought in 51.9%.

In the days immediately before the vote—although it was expected to be close—the polls suggested a slight tilt that the U.K. would remain; financial markets reacted positively, with stocks around the globe rising in value, along with most foreign currencies. Early Friday morning overseas, as it became clear that, in fact, the U.K. had voted to leave, these recent gains were reversed and there have been sharp declines in global equity markets, particularly in Europe and Japan. European currencies have also weakened relative to the dollar. Essentially, the markets were expecting a “remain,” were surprised by a “leave,” and thus are reacting negatively.
Though the questions surrounding exactly how and when the U.K. extrication from the EU will happen has caused near-term financial turmoil, the actual “leave” vote does not create an immediate change in the day-to-day functioning of the markets. Rather, it’s the beginning of a process that may take two years or more to fully execute. However, in the short term, there is some additional uncertainty politically: U.K. Prime Minister David Cameron has already announced his intention to resign. There are also upcoming elections in other European countries, including Spain, this weekend. All of these just raise more questions than the markets typically like to see, which is causing this near-term turmoil.

However, as the market gets over the Brexit shock and answers start to come on other fronts, this turmoil should settle some. The global economic system is better prepared to deal with financial panics than it has been historically. Most global banks are in much better shape than they were leading up to the financial crisis in 2008, and central banks are prepared to extend credit to institutions and countries to help them manage short-term liquidity problems if they arise.

The United States is insulated, though not immune, from events overseas. Although there has been a decline in U.S. stocks early today, it is smaller than the declines in foreign markets. The U.S. economy and the U.S. stock market are built on a foundation of domestic consumption of goods and services. Our economy is impacted by events globally, but it is not dependent on them.

In times of financial market stress, we must remember our investments are for the long term. This is a time for caution, but not panic or overreaction. Although our emotions might be telling us to act, we must resist this urge and strive to maintain a patient, long-term focus on the future. Some volatility may persist in the short term, and although we do not know for certain what lies ahead for the markets, the best course of action is to face it with a steadfast commitment to let reason, not emotion, drive our investment plan.

We are here to help you understand these very challenging times and will continue to keep you informed of all developments.

Thank you for your continued trust and confidence.

Sincerely,

Westside Investment Management

Market News

June 24th, 2016

The Markets

The Fed maintained interest rates at their current level following last week’s meeting, primarily influenced by May’s mundane employment report. That, coupled with a fall in global stocks, pushed U.S. stocks down as money seemed to move to gold and long-term bonds. Each of the indexes listed here lost value compared to the prior week. The Dow dropped 190 points and 1.06%. Since June 8, the S&P 500 is down 3.7% after falling 1.19% last week. The tech-heavy Nasdaq lost almost 2.0%, while the Russell 2000 dropped over 1.50%. Gold soared in price, crude oil remains below $50 a barrel after exceeding that mark a few weeks ago, and the yield on long-term Treasuries is down 65 basis points since the beginning of the year.

Crude oil (WTI) closed at $48.26 a barrel last week, down $0.68 from the previous week. The price of gold (COMEX) rose to $1,301.60 by late Friday afternoon, up from the prior week’s price of $1,276.30. The national average retail regular gasoline price increased for the fifth week in a row to $2.399 per gallon on June 13, 2016, $0.018 above the prior week’s price but $0.436 below a year ago.

Market/Index

2015 Close

Prior Week

As of 6/17

Weekly Change

YTD Change

DJIA

17425.03

17865.34

17675.16

-1.06%

1.44%

Nasdaq

5007.41

4894.55

4800.34

-1.92%

-4.14%

S&P 500

2043.94

2096.07

2071.22

-1.19%

1.33%

Russell 2000

1135.89

1163.93

1144.70

-1.65%

0.78%

Global Dow

2336.45

2333.86

2300.22

-1.44%

-1.55%

Fed. Funds rate target

0.25%-0.50%

0.25%-0.50%

0.25%-0.50%

0 bps

0 bps

10-year Treasuries

2.26%

1.64%

1.61%

-3 bps

-65 bps

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be
used to benchmark performance of specific investments.

Last Week’s Headlines

·
The Federal Open Market Committee held interest rates at their current range of 0.25%-0.50% following its meeting last week. The Committee noted that, while growth in economic activity has picked up and household spending has strengthened, the pace of improvement in the labor market slowed, job gains diminished, and inflation continues to run below the Committee’s 2.0% longer-run objective. Essentially reiterating a common theme of late, Chair Janet Yellen stated, “We continue to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate. We expect the rate to remain, for some time, below levels that are anticipated to prevail
in the longer run because headwinds weighing on the economy mean that the interest rate needed to keep the economy operating near its potential is low by historical standards.” It would appear that June’s employment report will have a significant bearing on
whether the Committee increases interest rates in July.

·
According to the latest report from the Census Bureau, consumers are spending more as retail and food services sales increased in May over April. Total retail sales and services came in at $455.6 billion in May, 0.5% over April and 2.5% ahead of May 2015. Retail trade sales were up 0.4% from April, and are up 2.0% from last year. Nonstore (online) retail sales were up 12.2% from May 2015, while health and personal care stores increased 8.3% from last year.

·
Increasing energy costs are pushing the prices manufacturers receive for goods and services higher. The Producer Price Index rose 0.4% in May following a 0.2% gain in April. In May, over 60% of the index gain can be traced to prices for goods, which climbed 0.7%. Prices for services moved up 0.2%. Prices less foods, energy, and trade services edged down 0.1% in May after rising 0.3% in April. For the 12 months ended in May, the price index less foods, energy, and trade services increased 0.8%.

·
Despite gains in consumer spending, the prices consumers are paying haven’t moved much. The Consumer Price Index for May showed prices increased a scant 0.2% over April (0.4% increase), while the core prices, excluding food and energy, also inched up 0.2%. Food prices fell 0.2% while energy prices increased 1.2%, reflective of a rise of 2.3% in gasoline prices. Over the last 12 months, the all items index rose 1.0%, while the index for all items less food and energy rose 2.2%.

·
The Federal Reserve’s Index of Industrial Production, which includes factories, mines, and utilities, fell 0.4% in May after increasing 0.6% in April. Manufacturing output moved down 0.4%, led by a large step-down in the production of motor vehicles and parts (-4.2%). Factory output, aside from motor vehicles and parts, edged down 0.1%. The index for utilities fell 1.0% as a drop in the output of electric
utilities was partly offset by a gain in natural gas utilities. After eight straight monthly declines, the production at mines moved up 0.2%.

·
Driven by rising oil prices and a weakening dollar, both import and export prices increased in May over April. Prices for U.S. imports increased 1.4% following advances of 0.7% in April and 0.4% in March. U.S. export prices advanced 1.1% in May after rising 0.5% the previous month.

·
Home-builder sentiment improved in June as the National Association of Home Builders Housing Market Index rose to 60 after four straight months at 58. Builders expressed renewed confidence in the market for newly constructed single-family homes in June. According to the NAHB report, builders are seeing more traffic and committed buyers. Breaking down index components, the future sales index gained 5 points to 70, future sales increased 3 points, and present sales jumped 1 point to 64.

·
Low mortgage rates and steady job growth have spurred activity in the housing market. However, a lack of inventory and rising prices have kept some would-be homebuyers away. Evidence of this can be seen in the housing starts (the beginning of construction) report for May, which saw privately owned housing starts fall 0.3% to an annual rate of 1,164,000. Single-family housing starts were at an annual rate of 764,000, which is 0.3% above the revised April figure of 762,000. Building permits for private homes increased 0.7% in May, but are off 10.1% compared to May 2015. Builders are apparently trying to keep up with demand as privately owned housing completions in May were 5.1% above the revised April estimate of 940,000.

·
In the week ended June 11, the advance figure for seasonally adjusted initial unemployment insurance claims was 277,000, an increase of 13,000 from the previous week’s unrevised level. The advance seasonally adjusted insured unemployment rate increased 0.1 percentage point to 1.6% for the week ended June 4. The advance number for seasonally adjusted insured unemployment during the week ended June 4 was 2,157,000, an increase of 45,000 from the previous week’s revised level.

Eye on the Week Ahead

The housing market is back in focus this week as May’s figures on existing home sales and new home sales are released.
In April, new home sales hit their highest rate since January 2008, while sales of existing homes increased by almost 2% from March. May’s figures are expected to continue to show progress, yet they may not approach the robust growth made in April.

Data sources: News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources such as government agencies, corporate press releases, or trade organizations. Market data: Based on data reported in WSJ Market Data Center (indexes); U.S. Treasury (Treasury yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.

Politics Unusual

June 22nd, 2016
We rarely discuss politics in our newsletters, mainly because political happenings in the developed world seldom impact markets in a significant way. The main exception is tax policy, which we have reported on in the past and will continue to follow closely.
This year, however, investors are eyeing two major political events. The first is the “Brexit” vote, which occurs later this week and is a referendum on whether the UK should remain in the European Union. The second is our own presidential election. The latter is usually a non-issue for the markets, as candidates from both major parties have tended toward the mainstream. By contrast, in 2016 we have a wild card, and he goes by the name of “The Donald.”
The UK: Should they stay or should they go?
Let’s deal with the impending event first. Until recently, it seemed unlikely that the UK would leave the EU. However, recent polls suggest that the result is too close to call, and markets have become justifiably nervous. If the vote in the UK ends up favoring a break with the EU, big changes are in store for Europe. (Since the UK continues to use the pound sterling, we are not talking about a country exiting the Euro as Greece was contemplating last year.)
The nature and extent of fallout from Brexit is largely unknown, although most pundits expect it to be harmful to both UK and EU economies. The biggest casualty would be trade between the UK and member countries of the EU, as a completely new set of trade agreements would have to be negotiated during the 2-year exit window in order to avoid significant tariffs, and this could be a tall order. Also, with the UK pulling out, there is concern that other peripheral countries might want to do the same, as Eurosceptic parties might continue to increase their political power.
We would not be surprised to see a negative response from markets should voters support leaving the EU, but any big moves are likely to be short-lived, especially since markets have already started to price in Brexit. Longer term, both markets and economies will adjust to the new reality. Mohammed El-Arian, chief economic advisor of Allianz even offers an interesting pro-Brexit case, suggesting that doom and gloom is not the only possible outcome.
At this point, we are not making major portfolio changes in anticipation of a Brexit, but are looking at potential winners and losers under this scenario. Paradoxically, UK exporters might do well post-Brexit because of a decline in the value of the British pound, as any potential increase in tariffs is still at least 2 years down the road.
Mr. Market bids one “No Trump”
US presidential election results rarely lead to big market moves, but if Donald Trump ends up winning, this year is likely to be an exception. At present, markets appear to have priced in a victory by Hillary Clinton: regardless of your political views, she is seen as the low-risk candidate because her policies are well known and she has a long track record in DC. And once Bernie is finally out of the way, her anti-Wall Street rhetoric is likely to tone down.
The problem with The Donald is that he represents a virtual unknown, with no government experience and policies that are not only fuzzy, but appear to change regularly. As you undoubtedly know by now, the markets hate uncertainty, and Trump has this in spades. If he were to win in November, US stocks would likely take a meaningful dip until his policies and the shape of his government became clear. Once these were known, markets would likely recover—either a little or a lot depending on the nature of those policies.
We will continue to keep a close eye on the progress of this year’s election. Should it look like a Trump victory is likely, we plan to adjust our exposure to US equities, potentially in favor of more foreign stocks. Although both may be affected in the very short term, over time non-US equities could benefit from political uncertainty here and a weakening US dollar.
Stay tuned. At least the election isn’t boring this year!
Best,
Dr. Ken Waltzer, MD, MPH, AIF®, CFA, CFP®
Managing Director, KCS Wealth Advisory
Laura Gilman, CFP®, PFP, MBA
Managing Director, KCS Wealth Advisory
Adam Bragman, CFA
Director of Investment Research, KCS Wealth Advisory