Markets this morning are chaotic, with most currencies falling against the safe-haven US dollar, gold rising and stocks falling. Investors are understandably concerned and worried that we will see a repeat of the 2008 market meltdown. Are they right to be worried? Our answer: for most investors there is little to fear and nothing to do. Here’s why.
1. Over the next two or so years, the UK and Europe will negotiate the terms of the UK’s exit from the series of treaties that allow free trade, free travel and easy immigration. Nobody knows how these negotiations will play out, since this is a novel situation. It is manifestly in the interests of both Europe and the UK to keep trade in goods and services as free as possible. No doubt there will be changes and there every reason to believe that the UK will end up poorer as a result. UK banks in particular have a lot to lose, as do farmers. The UK could fall into a recession but this is far from a sure thing. The instant devaluation of the pound today, down as much as 7%, makes UK exports easier, but makes imported goods more expensive for its residents. This will result in inflation at the consumer level, and a real drop in the standard of living. The UK has the fifth largest economy in the world, so a weak UK is bad for global economic growth. The impact on the European economy is very hard to gauge at this time and we will be monitoring events closely as negotiations proceed.
2. We invest in companies we think will make profits. From these profits they pay dividends, and as profits increase, the value of their shares increase. Will Brexit impact the profits of our portfolio companies? Perhaps for some multi-national companies, but mostly in a small way. For example, McDonald’s (a company we do not own) sells in the UK, and as the value of the pound drops, the value of its sales, measured in US dollars, will drop. A UK recession could also lead to slower sales in that country. So it is possible to imagine that McDonald’s profits could fall say 15% in the UK. But the UK makes up only 6% of its total sales, so the total impact on profit would likely be no more than 1%, and probably much less. The same would hold true for most US global companies.
3. Canadian exports to the UK amount to about 3% of all Canadian exports. The greater part is comprised of commodities (gems and precious metals). The total value of manufactured goods Canada sells to the UK is about $1 billion per year, an insignificant part of total exports, and a rounding error in its $2 trillion GNP. Very few, if any, of our Canadian portfolio companies will see a significant impact on profits as result of Brexit. There is no financial reason for the Canadian dollar to be down, or for the Canadian stock market to fall.
4. The 2008 financial crisis was a result of severe liquidity and solvency problems in the world banking system. This led to the failure of a major US investment bank (Lehman Brothers) and a freeze-up of the world banking system. The Brexit situation is completely different, having to do only with the unwinding of trade agreements in Europe. In addition, banks are much stronger than they were in 2008 as a result of concerted efforts around the world to build more robust balance sheets. Central banks are much more alert to credit problems and liquidity issues than they were in 2008, and stand ready to ensure markets function normally. We do not think there is any chance of a structural or systemic market failure such as we feared in 2008.
Fear and uncertainty lead investors into error. Many will sell in panic and be left on the sidelines when markets rebound. We see no reason to change our stance on the markets. Our expectation is that this market moment will, like many before it, fade into insignificance over time. Except for those who panic and sell.
David Baskin, June 24, 2016
