Britain’s vote to leave the European Union was a shock, as evidenced by the abrupt nosedive seen in global financial markets in the immediate aftermath of the referendum. It raises the question: how nervous should investors be over Brexit?
Not nervous at all, a Brexiteer might say. Some argue the media has overstated the level of panic in financial markets. Although the FTSE 100, for example, saw heavy selling in the two trading days after the vote was announced, it merely brought the index back to levels seen less than a fortnight earlier. Markets, confident that Britain would vote to remain, had climbed sharply in the days leading up to the vote; post-poll losses were swollen by the unwinding of those bets. And, even then, the subsequent rebound saw the index return to its pre-Brexit level within days.
Nevertheless, it would be facile to downplay the market panic, both in Britain and beyond.
The FTSE 100 is largely made up of multinationals that make most of their money outside of the UK; investors' assessment of what Brexit means for British economic prospects is better gauged by the domestic-focused FTSE 250 index, which suffered its largest one-day drop since 1987.
Additionally, sterling recorded its fastest decline in history.
Denominated in dollars, the FTSE 100 fell by 15.3 per cent in the two days following the referendum result, its biggest two-day decline since Black Monday in October 1987.
Of course, as Irish investors well know, the crash was not confined to the UK, with the Iseq suffering a two-day decline of 17 per cent. Other European indices were similarly brutalised; France’s Cac-40 fell by 10.6 per cent, its third-biggest two-day decline since 1987. Spain’s Ibex 35 fell 13.8 per cent, its largest two-day decline since 1987.
The euro's decline means European equity losses would look even more severe to United States investors. Bespoke Investment Group notes that in dollar-adjusted terms, equities in Germany, France, Spain and the UK all suffered two-day double-digit losses, something seen on only two occasions over the last 30 years.
Losses outside Europe were less severe but notable nonetheless – globally, stocks declined in value by a record $2.08 trillion in the day following the referendum.
Political contagion
Stocks have enjoyed big gains as well as big losses since the Brexit vote, and many strategists see markets remaining volatile for some time. Merrill Lynch has urged would-be investors to be patient, saying the sell-off "may go further than the market expects", with "multiple years of referendum-induced uncertainty". That was echoed by a Barclays note entitled "Don't be a hero", the message being that market shocks can take time to fade. Similarly, Deutsche Bank has warned that Brexit will likely have "lasting implications" for the European banking sector.
Franklin Templeton's Michael Hasenstab, who is not averse to trying to catch falling knives – he made billions by buying Irish bonds at the height of Ireland's financial panic – is also cautious. The shock to Europe, Hasenstab cautioned, "could be a little more permanent, and people will likely begin to question investments in the euro zone over the longer term".
The uncertainty catalysed by Brexit is, as Merrill puts it, “multidimensional”, with obvious question marks hanging over the future nature of the UK-EU relationship, the future geographical make-up of the UK, the health of the European banking sector and the policy response of monetary and fiscal authorities around the world.
George Soros warns the "very survival of the European project" is now at risk, with Brexit likely to "open the floodgates for other anti- European forces" within the EU.
France's National Front is calling for "Frexit", Dutch populist Geert Wilders is seeking "Nexit", and similar noises are emanating from anti- EU politicians in Italy, Sweden and Denmark.
Political risk is also Hasenstab’s main source of concern: he was “convinced the euro zone would stick together” at the height of the European debt crisis in 2011 but cautions that “broad political will is quickly deteriorating”. He envisages more referendums and more nationalism that “will create a tremendous amount of volatility and a difficult period in the euro zone”.
Investors clearly share these same fears of political contagion, as evidenced by the fact that Italian, Spanish and Greek indices all suffered even larger declines than those seen in the UK in the aftermath of the referendum.
Technically, there is room for further downside. In the US, the S&P 500 was near all-time highs prior to the Brexit vote, and the index is nowhere near the oversold levels registered in February that helped catalyse a strong multi-month rally. Selling in Europe has been much heavier, but indices last week hovered above February’s lows.
Based on previous European crises, Merrill Lynch has modelled a 16 per cent correction for European stocks which "should take us through the lows of February". Furthermore, it expects the selloff to be "sustained due to an increased risk premium for European equities". Risk-modelling firm Axioma continues to warn that both British and European indices may not bottom until a fall of about 25 per cent has been registered.
Cheap stocks
However, it's not all grim. Europe may be a mess, but European stocks are quite cheap – "For investors who are willing to be patient, that's usually a good combination", says blogger and Ritholtz Wealth Management strategist Ben Carlson.
German-based investment firm StarCapital notes that all but two countries in Europe are cheaper than the US in terms of indices’ cyclically adjusted price-earnings ratios (unfortunately for Irish investors, the Iseq is one of those two countries, or at least it was prior to the recent sell-off).
Various other valuation metrics confirm this valuation picture. Cheap stocks can get cheaper, of course, and the US-Europe valuation gap has persisted for years. Nevertheless, it’s worth remembering that historically, long-term equity returns in the countries with the lowest economic growth have tended to comfortably outperform those with the fastest GDP growth.
Secondly, while uncertainty abounds at the moment, history suggests that equity market ruptures caused by geopolitical shocks do not tend to be lasting affairs. Over the last century, geopolitical shocks have tended to impact major markets by 10 per cent or less, according to Credit Suisse analysis, with markets usually regaining their mojo within a month or so.
That tallies with recent analysis of 20 previous market shocks conducted by Sam Stovall of S&P Global Market Intelligence: on average, stocks bottomed within 32 days, falling by 10.3 per cent during that time. Typically, stocks had recouped their losses in less than four months.
Of course, some shocks are obviously worse than others; stocks almost halved in the months following Lehman Brothers’ collapse and it took investors more than two years to get back to break-even. Furthermore, there is good reason to think that the hangover from Brexit could be a lengthier affair, potentially depressing European valuation multiples for some time to come.
Surviving market shocks
Nevertheless, it’s undeniable that diversified investors tend to be rewarded for exercising patience in times of perceived crisis. Data from Dimensional Fund Advisors (DFA) shows that a portfolio made up of 60 per cent stocks and 40 per cent bonds would have returned 21 per cent within a year of the October 1987 market crash and 61 per cent after five years; the Russian financial crisis in September 1998 resulted in a global rout but the portfolio had gained 20 per cent a year later and 52 per cent after five years.
The 60:40 portfolio eked out a 3 per cent gain in the year following the March 2000 dotcom crash and was 55 per cent higher after five years. Within five years of the September 11th, 2001, attacks, an 84 per cent gain had been recorded. Five years after Lehman’s collapse, the portfolio was 43 per cent higher.
None of this is to downplay the significance of the Brexit vote. Things may get worse before they get better and the turmoil may last longer than expected – who knows? Still, it’s difficult to argue that Brexit is necessarily a more grave event than the examples cited by DFA.
Selling up after a major market shock is rarely a good idea; for diversified investors, the best thing to do may be to do nothing.
