Client Letter: Second Quarter 2016 - Market Review - Self Inflicted Brexit WoundsSubmitted by Alsworth Capital Management, LLC on July 19th, 2016
As the second quarter ended, investors could be forgiven for feeling bruised, battered and knocked around. In the aftermath of the Brexit vote, global financial markets initially hit the panic button only to largely recover later. As you know from previous letters I’ve written, I believed there to be a relatively low probability of Britain voting to exit the European Union. So this was definitely a surprise, as was the markets quick recovery. The decision has serious negative ramifications for the British economy and creates instability at the worst possible time. The exit vote was driven largely by immigration concerns and the European Union’s insistence that all members adopt free flowing borders as a condition of membership. The free flow of goods, capital and human resources (workers) is a key tenant of a successful capitalist free market system. When things were going well this seemed to work swimmingly. But, as globalization and robotized production lines have taken root, worldwide wealth is being spread out across a larger global population and less labor is needed to meet production needs. This has caused stagnant wages and reduced the need for lower skilled laborers. This pool of lower skilled workers is hurting financially and facing increased competition from people that don’t look like them. This has created insecurity and it is leading to populism and political realignments around the globe. I am sympathetic, but the Brexit vote was an unfortunate decision in my opinion and a self-inflicted wound, as citizens ultimately voted against their own best interest. In an effort to close off their society, I believe they are ultimately insuring that they will lose out economically to an increasingly globalized commerce system. The lack of stability and uncertainty created by the decision will hurt the London financial sector, giving up hard fought gains to more secure New York financial firms. The tighter capital flows will make it harder for small British businesses to secure loans and grow their businesses. There may not be an immediate recession or financial contagion, thanks largely to the huge amounts of excess capital currently available in the system from central banks. However, the long term structural impact is likely to be quite negative for Great Britain and the average British citizen.
The broad international developed market index ended the quarter down a slight 0.1%, and down 1.9% year to date, while the Europe-specific index fell 1.9% and 4% for the quarter and year to date periods, respectively. While equities started to rally less than a week after the Brexit vote, we haven’t viewed that as an opportunity to take a breather. We continue to assess the short and long term impact, including the likelihood that central banks will intervene to support financial markets. We also expect potentially greater downside risk as investors, politicians, central bankers, and a host of others, digest recent events. However, we have conviction in our current target allocations with respect to Europe and we believe that the largest European companies will still have plenty of access to capital in the global banking system. Additionally, Euro currency members may actually benefit from the weaker Euro, which makes their products cheaper to consumers with stronger currencies like the dollar.
I am frequently asked whether the current market volatility presents a buying opportunity. My quick answer is that it might. For now, European equities have not fallen to the point where we see a compelling benefit from adding to our position. Should further declines relative to U.S. markets occur on the same order of magnitude as the ones in the first few days after Brexit, we may consider adding to our exposure. The European position is well diversified among the European countries, beyond just Great Britain. It is also market cap weighted, which favors the largest companies with the highest percentage allocation. Overall valuations are attractive and any further declines could make the sector more compelling.
And what about emerging markets? They held up well during the markets’ post-Brexit panic, benefiting from expectations that the Federal Reserve will delay raising U.S. interest rates. Emerging-markets stocks finished the quarter up 4.9% and have gained nearly 9% year to date. Importantly, we continue to view our emerging-markets positions as having attractive long-term return potential given earnings growth trends and current valuation multiples, despite higher potential short-term downside risk.
Our positions in managed futures performed as expected during this quarter as they were a positive contributor to the portfolio while the stock allocation was in decline. They have given back some of those gains as the stock market has recovered, but this lack of correlation has benefit the overall portfolio volatility. We continue to monitor these positions closely and are pleased with the current allocation.
We believe that a more cautious overall approach to markets in the midst of elevated valuations and higher volatility is justified. We also believe that emphasizing lower valuation segments of the market is warranted, as we have a harder time generating sufficient returns from more traditional holdings. This leads us to using more cash like fixed income positions and managed futures holdings to dampen volatility, while simultaneously holding overweight positions in emerging markets and developed international stocks. As always, we will be proactive in taking advantage of compelling investment opportunities where we see temporary market mispricing and/or overreaction. Should markets decline more precipitously, we expect to utilize some of our dry powder to buy assets at lower prices. For now, though, we wait.
The bottom line is that we will continue to safeguard the assets you have placed with us by sticking to our investment discipline of riding out short-term swings and only adding tactical exposure when our view of valuations and expected returns is warranted. In the short term, this kind of market volatility can certainly be cause for concern. However, we believe that overreacting to these market shocks is absolutely the wrong response for investors with a long-term investment focus. Running with the herd may sometimes seem like a safe option for some, but for us “this way madness lies.”
If you would like to discuss recent market events or have questions specific to your portfolio, please don’t hesitate to let us know.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
Advisory services offered through Alsworth Capital Management, LLC, an independent Registered Investment Advisory firm. Broker Dealer services offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC.
Alsworth Capital Management, LLC and Cadaret, Grant are separate entities.