Political risk does not always spell a downward spiral for equitiesMarket view from Azzad Asset Management. Reprinted with permission. Visit www.azzad.net
The United Kingdom’s exit from the European Union, or “Brexit,” became official Thursday with 52% of the vote. As expected, markets are reeling from the resulting uncertainty.
Even though there is no precedent for what’s to come, we know a couple of things for sure.
First, it will take two years to formally withdraw from the EU, which means that investors get to fret over this decision for many months to come. Second, and more importantly for US investors, American companies have very little exposure to companies on the other side of the Atlantic.
According to FactSet, the S&P 500 has a mere 2.9% sales exposure to the UK. Even the most exposed sector, energy, derives only 6.4% of sales from the UK. This is an important point to remember as you wade through all of the articles outlining the political implications of the UK withdrawal.
Although much ink has been spilled in an effort to explain the political consequences, not nearly as much attention has been given to Brexit’s impact on markets longer term.
S&P Exposure to UK About 9%
The chart below shows the exposure of the S&P 500 to the UK by business sector:
Additionally, according to a recent Citigroup report, Europe directly accounts for just 9% of sales for the companies that make up the S&P 500. That, along with the fact that most of those sales come from stable categories like food, beverages, and pharmaceuticals, means that the British decision to leave the EU is not likely to have a dramatic impact on those companies’ bottom lines.
Does this mean there’s nothing to worry about? No, the Brexit decision certainly bears watching, and we are monitoring the situation closely at Azzad. But clients should understand that political risk is a different category of concern, one that does not necessarily indicate a prolonged downward spiral for equities.
It’s also important to distinguish between short term and long term. In the short term, perhaps over the next few days or even weeks, there will certainly be dislocations stemming from this negative shock. Long term, emotional investing is likely to subside and cooler heads to prevail.
The bigger picture
There’s an old saying that goes: “Fool me once, shame on you. Fool me twice, shame on me.”
Whether it’s the slower-growth Chinese economy, Greek insolvency, or European banks, external shocks to US markets and the economy have become par for the course. What we have seen from each of these events, however, is that beyond the initial volatility, there has been relatively minor damage to the overall prospects for steady, albeit slow, global growth.
As sure as markets turned on fears about those events, investors will doubtless get a case of the jitters as we enter the unknown territory of a post-Brexit world. We expect, however, that markets will recover in similar fashion, presenting opportunities for patient investors.
As during those previous events, markets are currently being driven by emotion, rather than a substantial change in fundamentals. Although data have indicated problems with corporate earnings over the past several quarters, we have seen nothing to indicate a major blow to the United States. And all indications point to an accommodative Federal Reserve holding off on further interest rate hikes pending the outcome of what will be a long process for the UK to extricate itself from the EU. This is in addition to global central banks stepping in to provide liquidity and other measures to ensure market stability.
What to expect now
Investors should not be surprised to see more turbulence over the short term. But remember that volatility can be your friend. Without it, you couldn’t make money in the markets.
When you own stock in a company, you own part of a business. The value of that business does not fluctuate as wildly on a day-to-day basis as its stock price. This means that its market price at one particular time may not accurately reflect what your ownership stake in the business is worth. When stock prices are affected by outside forces that can temporarily drive down prices, you have an opportunity to pick up quality companies at a bargain. That’s where we come in. Our portfolio managers are focused on quality companies and quality returns—regardless of market environment.
We can expect to see more volatility as markets reprice and we adjust to the new face of Europe. If you’re in need of cash within the next few months, you should not be invested in stocks. Consider taking some risk off the table and reallocating to fixed income. (Sukuk appear to be relatively resilient in the wake of Brexit.) If you’re a longer-term investor, however, stay the course.
If you’re in it for the long term but still have trouble sleeping at night, we can talk about rebalancing your portfolio to get you back in line with your original asset allocation. And if you’ve got cash sitting on the sidelines, think about deploying it. As legendary investor Warren Buffett says, “Buy when there’s blood in the street.”