BREXIT

Bill Miller, CFA

In general, I share the view of Oaktree’s Howard Marks who said “I have trouble viewing [the UK’s decision to leave the European Union] as a financial catastrophe.” It is a psychological shock as the markets were expecting the opposite outcome, and it creates uncertainty in the near term, and markets hate uncertainty. I think the actual economic impact is likely to be modest, even in the UK, and very small in the US and perhaps none at all.

I do not have any particular insights into the actual economic consequences of the vote, which range from benign (a moderate correction in the US market of probably no more than 10%, and in European markets of say 15%), to concerning (a recession in the UK, which I think relatively unlikely), to severe (other countries such as Greece or Spain voting to leave which would raise the specter of a potential unraveling of the common Eurozone). It will take at least two years just to work out the details of Britain’s leaving, which means a good bit more macro uncertainty. The Fed will surely be on hold for a while and be even more “data dependent”. Winners include most of what has been winning since the 2008-09 financial crisis: bonds, utilities, staples, as upward pressure on rates at least right now is absent. Losers in the short term anyway are some of the things that have worked since mid February, such as energy, materials, and industrials which were hit pretty hard Friday. Financials are under pressure due to the drop in bond yields. I do not expect bonds to drop below the 2012 low yield of 1.38%, nor do I expect the US market to drop to the levels we saw in mid-January and mid-February as we are passing through the year-over-year trough in earnings, and both earnings and dividends should be growing in the next twelve months. I do not see this as posing any Lehman contagion-type risk as Central Banks have contingency plans in place and will be quite accommodative.

The action on Friday was less severe in our market than I would have expected given the rally of the previous few days in anticipation of the opposite outcome. In our portfolios, there is nothing too unusual going on given how the market is acting. Opportunity is more cyclical and higher beta, and the names down the most are the ones with those characteristics. Income Opportunity was way ahead of the market at the close on Friday, and as of this writing is up 1.6% for the year and 79bps ahead of the market¹. Some stocks such as US homebuilders are getting hit for no reason except people are net selling. They have no exposure to Britain or Europe, the housing market is doing very well and that should continue for several more years, and lower mortgage rates are good for housing and refi’s.

We think there may be some bargains becoming available in the UK market if we do get a deeper correction there in the next few weeks, especially with the pound now at 30-year lows so it is likely we could get a currency tailwind on names over there.

In events such as this that inject volatility into the market and disrupt prices, we will be looking for bargains that may arise due to the emotional reactions of others.

Bill Miller IV, CFA

The market’s reaction to the UK’s decision to leave the European Union reflects more surprise and fear than economic reality at this point. The severity of the reaction is largely because of how unexpected it was, given that neither bookies nor markets anticipated it. Reality is that the untangling of the UK from the EU will take time and lots of political wrangling, and it’s not clear where the trade and immigration policies will shake out, though both will likely be worse off than they are now. The broader market fear is that irrational and isolationist reactions will spill over to other countries, which would be a big negative for global markets and asset prices. Only time will tell if this happens elsewhere.

Samantha McLemore, CFA

I think this is one of the maximum points of uncertainty that I’ve experienced in my career. After Lehman Brothers, it was clear things were dire and the question was whether monetary and fiscal policy could mitigate the disaster. Now it’s not clear at all what the economic consequences will be. Fed funds futures now project nearly equal odds of a rate hike as a rate cut in September and November – that is highly unusual that even the direction of the next rate move is unclear. I’ve heard some smart people warn of the possibility of an extreme outcome and others say this is a buying opportunity. I listened to a call with Mervyn King, prior head of the BOE. His main point was that no one has a clue about the actual economic consequences. His guess was that the long term impact is over estimated.

¹The performance figures reflect the deduction of a model investment management fee of 1% (the highest fee for separate accounts under our fee schedule) and certain other expenses. For important additional information about Income Opportunity Strategy performance, please click on the Income Opportunity Strategy Composite Performance Disclosure. The performance returns shown in this report are preliminary and are subject to revision. Past performance is no guarantee of future results.

Any views expressed are subject to change at any time, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.