FPA Capital Fund commentary for the second quarter ended June 30, 2016.

H/T Dataroma


The second quarter of 2016 will be remembered as the time when the United Kingdom (UK) voted to divorce from the European Union (EU). The UK and the EU have been together since 1973, but the British decided that the relationship was no longer in their national interest, and on June 23, their citizens voted to “leave” the EU.

FPA Capital Fund

On voting day, as soon as it became clear that the “leave” campaign had the majority of votes, the global capital markets experienced the equivalent of a financial earthquake. Based on the Richter scale, the Pound Sterling’s rapid decline of 10% versus the U.S. Dollar would be similar to a 7.0 quake, and there could be economic aftershocks in the months ahead as divorce discussions get underway. The subsequent two-day U.S. equity decline of roughly 5% could be characterized as a more modest 5.0 magnitude trembler, yet it was still large enough to unnerve many investors.

The net result for U.S. equity investors is that the second-quarter and year-to-date returns, respectively, were in the low single-digit category. The second-quarter and year-to-date return for the S&P 500 was slightly above 2%, and a shade below 4%, respectively. For the Russell 2500, second-quarter and year-to-date returns were both around 4%. The Capital Fund’s second-quarter and year-to-date returns were 2.52% and 1.89%, respectively.

However, just as an earthquake-rattled house can look fine on the outside and be wrecked on the inside, the moderate year-to-date returns in the U.S. equity markets are a facade that masks hidden volatility. For instance, from the beginning of the year to its low in February, the Russell 2500 declined nearly 15%. Then it reversed course and appreciated nearly 25% from its February low to its pre-Brexit June high.

Perhaps the increased volatility in the second quarter portends a change in the seven-year bull market. On the other hand, we have seen the equity markets tremble a couple of times since the great recession ended in 2009, only to resume their seemingly inexorable appreciation. This latest episode may be just another period where equity investors grab a quick rest before returning to the market to satisfy their appetite for more risk.

FPA Capital Fund – Market Commentary

As we mentioned above, the most important event that occurred in the second quarter was that the UK voted to exit the European Union. While we do not fashion ourselves to be geopolitical experts, we believe it is necessary for our shareholders to hear our thoughts on what this momentous vote means.

In the short-run, say over the next year, we do not believe the so-called Brexit (Britain exit from the EU) will have a substantial impact on the global economy. The reason is that we believe it’s very unlikely that the UK will actually exit the EU within the next twelve months. On the other hand, there will likely be an economic slowdown in the EU region, with the UK experiencing a more pronounced slowdown due to the vote. This is because businesses and investors, at this time, are very uncertain of what the final divorce settlement will look like. Thus, there should be a natural slowdown of capital expenditures and investments in both regions. Nonetheless, both sides have stressed that they want to preserve as much of the EU economic relationship as possible, at least in the short term.

Obviously, some industry sectors will experience greater short-term impact than others. For instance, City of London commercial real estate tied to the financial services sector could see less incremental demand than retail sales at Burberry’s stores in high-traffic tourist locations. This is because the cheaper pound will likely stimulate more tourist activity in the latter, but Brussels will likely try to claw back more capital-market trading and clearing activities from the former for its remaining EU member states. There will also be currency translation issues for multi-national companies doing business in the UK and Eurozone (EZ), but these currencies have been weak for two years, and most of the decline had already occurred before the Brexit vote.

Turning to the long-term ramifications of the vote, it is unclear what the outcome will be for the global economy. On the one hand, there is a large tail risk to the capital markets should other EU members choose to exit and, as a result, call into question the viability of the Euro currency as it is currently constructed. Some politicians in Denmark, Sweden, and the Netherlands have agitated for their respective ruling governments to hold a Brexit-style referendum on EU membership. Most people would question the economic logic for any of these three countries leaving the EU. However, many UK “leave” leaders were driven by their desire for the country to regain its independence from rules and regulations from Brussels—directives they considered an infringement on the UK’s sovereignty. In other words, economics played second fiddle to the political choice of regaining an independent, sovereign country.

Italy and Greece are being deluged by substantial numbers of migrant refugees from other parts of the world. Politicians from both countries have expressed dissatisfaction with Brussels’ response to the migrant crisis thus far. Italy also has a brewing banking crisis, and the current Italian Prime Minister wants to subvert the EU’s bank “Bail-in” rules because they could hinder Italy’s preferred method to recapitalize its major banks. As a reminder, the Italian banking sector has a current non-performing loan (NPL) ratio1 of 17%, which is more than triple the NPLs held by U.S. banks at the height of the financial crisis in 2009, according to the Wall Street Journal2. Moreover, the Five Star political party in Italy recently won the mayoral election in Rome. This is noteworthy because the Five Star party has campaigned for Italian voters to decide whether the country should retain the Euro as its official currency.

On July 5, 2016, Hungary announced that it will hold a referendum on October 2, 2016 that will allow voters to decide whether the country should abide by mandatory EU migrant quotas. This referendum and other potential European referendums threaten to further destabilize the EU and potentially cause a domino effect, where more countries could follow the precedent the UK established. Businesses and investors are rightly concerned about the ramifications of the EU splintering into two or more pieces. From our perspective, if European political leaders do not find acceptable solutions to major grievances from their member countries, Brexit may be just the first domino to fall.

On the other hand, the UK has not officially filed the divorce papers–known as Article 50 of the Lisbon Treaty—and there is no guarantee that it will. If Theresa May, the new UK Prime Minister, is able to negotiate with the EU leadership an amicable agreement whereby the current EU migrant policy is halted and the UK is allowed to put in place some reasonable immigration caps, it is entirely plausible that the UK will not sign Article 50.

This outcome would be viewed, in our opinion, as a net positive by the equity markets–at least in the short run. That’s because the large tail risk of an EU political collapse

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