Europe is a collection of countries that used to argue with each other (a lot!). During WWII, many countries within Europe fought against each other, further hurting the continent. After WWII, these same countries needed to trade with each other, but incurred too many trading obstacles.
Tariffs and other issues slowly led countries to join a common union in an effort to reduce red-tape hurdles. The sharing concept was appealing, as it made it easier for member countries to work together. Unfortunately, this sharing concept also made it easier for weaker member countries to game the system and rely on stronger European Union (EU) members.
issues within the eu
As timed passed, stronger EU members began to question the support required to help weaker EU members. As unemployment rose, tax revenue declined and debt burdens rose within weaker countries, and the burden on stronger members began to shift public opinion away from the EU concept. To make matters worse, the ease with which immigration between countries could occur caused stronger members to experience an immigration issue (as immigrants flowed into stronger countries looking for jobs). In a survey conducted earlier this year, over 45% of people in Britain identified "immigration/race relations" as a top issue facing the country. This issue was enough to tip Britain into a "Leave" vote and the decision to exit the EU (also known as BREXIT) on June 23, 2016. Looking forward, we expect these EU countries to start to bicker at an increasing rate. This will be especially true among the core EU members (Germany, France, Netherlands, Italy, etc.) as they decide what barriers need to be re-established with the UK. Note the complicated graphic of the Eurozone and EU below. Clearly these countries have created a tangled mess.
*Chart Source: Financial Times
Implications of BREXIT
The question now is how BREXIT will impact the market looking forward. While the ramifications of this event will take time to fully understand, there are a few key themes that we are watching very closely. Currency trends, global growth trends, and corporate earnings guidance will all be adjusted because of Britain's decision to exit the EU.
First, within the currency markets, the US Dollar will probably trend in a stronger direction (relative to global currencies). This could potentially have a major impact on the markets. For example, over 45% of aggregate corporate revenue within the S&P 500 Index is from exports. If the US Dollar strengthens too much (or too quickly), export revenue will soften within companies. This will hurt corporate earnings, global growth guidance and ultimately consumers on a global basis. Moreover, weak currencies abroad will slow down imports into those countries. The net effect of all of this is slower growth and lower corporate earnings. This translation will not occur overnight, but will be more of a slow-moving train that drags the market guidance lower over an extended period.
According to Ned Davis, households' financial asset allocation to stocks was nearly 52% at the end of Q1-2016. When investors are nearly fully invested in stocks, the next few years tend to be below average years for the markets. Slower growth expectations will only amplify the reduction in return averages. In the graphic below, we can see that investors are over-allocated to stocks relative to their historical mean.
*Chart Source: Ned Davis
Secondly, within corporate earnings, we see that companies are already experiencing a corporate earnings recession. Q1-2016 earnings within the S&P were $23.97. At this level, the market is still trading at over 21x earnings. This is way above the historical average market multiple of 15x to 16x. Looking forward, we expect corporate earnings guidance to be slowly lowered. This will probably occur in Q3-2016, as companies lower expectations under the cover of a stronger US Dollar, a slowdown in global trade activity and a general slowdown in global growth estimates. In many ways, BREXIT may change the earnings equation looking forward.
According to Factset, companies that generate more than 50% of their sales from outside the US will potentially see an estimated sales growth decline of 9% in the future. The same is true for earnings. Factset is now estimating that those companies with 50% of their sales outside the US expect to experience an earnings decline of 9% to 10% looking forward. This is due to the combination of a stronger dollar and weaker global growth estimates.
On June 24th, Factset noted that for Q2-2016, the estimated earnings decline is -5.2%. If the index reports a decline in earnings for Q2, it will mark the first time that the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3-2008 through Q3-2009.
Lastly, we expect global growth estimates to decline because of BREXIT. Since the vote to exit the EU, we have seen that both Moody's and S&P have cut the UK's credit rating. Moody's cut the UK's credit rating outlook to "negative" on June 25th. S&P followed shortly thereafter and cut the UK's credit rating from AAA to AA. On July 30th, S&P then cut the EU's overall credit rating from AA+ to AA. This adjustment will increase the borrowing cost for all 28 member countries within the EU. As the EU countries start to argue at an increasing rate and re-establish trade barriers, growth will slow. We expect global GDP growth estimates to decline over the summer months. We also expect US GDP estimates to slightly decline (thanks to currency issues).
With these thoughts in mind, we plan to keep the portfolios underweight equities and overweight bonds. Moreover, within the remaining equity allocation we will continue to overweight lower volatility positions as the market continues to digest a fractured European Union. In addition, we will remain overweight money market (cash).
Please contact us at (972) 684-5923 if you have any questions.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.