Ariel Investments commentary for the month ended June 30, 2016.
Obviously, the Brexit vote was the big event this month, and what a short, strange trip it has been. On June 23rd, the United Kingdom’s citizens voted whether to Remain a part of the European Union (Bremain) or to Leave it (Brexit). This referendum was born in 2013, when Prime Minister David Cameron promised there would be a stay/go vote if he were re-elected. At the time, low rumblings came from some who were dissatisfied with the E.U.; Cameron firmly believed in the Union. He considered the referendum low risk—he was wrong. Leading up to the vote, the British political betting markets showed an 88% chance Bremain would win; public opinion polls leaned that way but less firmly. In the end, more than 30 million voters (greater than 70% of eligible voters) voted to leave the E.U. by a 52% to 48% margin. Experts were stunned, the media scrambled, and the British pound fell -10.67% (versus the dollar) in just two days. Cameron announced he would resign.
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Ariel Investments – Brexit effects
The announcement of this great divorce had an enormous ripple effect over the next few days. In just two days the British stock market (the FTSE 100) plummeted -15.79%. Meanwhile, international stocks dropped -9.84%, the U.S. large caps fell -5.34%, and small caps slid -7.04%. Moreover, there were fears of a domino effect politically, with speculation that other nations could move to exit—including France, Italy, Denmark, the Netherlands, and Hungary. There were also economic worries that Europe (including the U.K.) would experience slow growth; some even considered recession to be a near certainty. There was universal agreement interest rates would remain at near-zero rates for the foreseeable future. And, to be sure, global trade policies would be shredded; thousands of lawyers would begin working long hours to create new multi-national agreements. Indeed, there was almost immediate buyer’s remorse: roughly four million British citizens signed a petition for a second referendum in order to reverse the vote.
When emotions run high as the political and economic landscapes tilt, market inefficiencies typically occur. As we have said many times before: we think the market is very efficient at most times and in most places—but not always and everywhere. Indeed, after the two day collapse, the markets recovered significantly. Since June 27th through July 1st, the FTSE 100 has gained +10.51%, the MSCI EAFE Index was up +6.63%, the S&P 500 Index jumped +5.17% and the Russell 2000 Index +6.24%. So the S&P 500 is now down only -0.44% from the day before the vote. During this mini-crisis we saw clear signs of irrational selling—babies being thrown out with the bathwater. Take the financial sector, for instance, where some companies make their profits via interest rate spreads, and others earn money through fees. Because Brexit pinned interest rates to the near-zero mat, it made sense to sell large banks and insurance companies—low rates severely constrain their profits through pinched interest-rate spreads. On the other hand, some companies profiting from fee income, such as asset managers, arguably benefit from low interest rates. As you know, rising interest rates put pressure on equities, but falling interest rates boost their valuations. Yet asset managers owned in some Ariel portfolios fell hard. In just two days, Janus Capital Group Inc. (JNS) fell -12.28%, Franklin Resources, Inc. (BEN) declined -11.31% and T. Rowe Price Group, Inc. (TROW) retreated -8.03%. They have recouped some, but not all, of their losses. When we see these kinds of dislocations, they look much more like buying opportunities than sell candidates.
So what does all this mean for investors? First and foremost, it is critical to realize sell-offs, like this one, are relatively small. After all, equity bear markets often mean drops of -25%, -30% or even -40%. Everyday investors must be prepared to weather such storms. For the professional investor, such sharp drops are like clearance sales: when one is picky and knowledgeable, remarkable bargains are available. For most investors, however, we think the advice of the great Jack Bogle is very much in order: “Don’t do something—just stand there!”
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