The UK has voted to leave the EU, and the financial markets have reacted strongly. That’s about all anyone can confidently say at this point. We really are in uncharted territory here. Before we talk about what you should do going forward, it’s worth stepping back and looking at how we got here.

The UK joined the European Economic Community in 1973. The EEC was focused on integrating the markets of Europe and allowing freer trade between member states. Over time, this evolved into the European Union, which further integrated economic markets, standardized regulations, loosened border controls, and introduced a common currency (the Euro). While the UK was a member of the EU, they always stood a little apart. The UK never adopted the Euro, didn’t fully dismantle their border controls, and consistently bristled at the EU bureaucracy in Brussels.

So why was there a referendum on Britain exiting the EU (which is where the term Brexit comes from) now? There are a whole bunch of individual reasons, but there are two overriding factors:

  • Economic Issues
  • National Sovereignty

Economic Issues

The European economy has been a bit of a basket case for a while now. There have been extremely serious issues with many southern European states (and a number of them, especially Greece and Italy, are still pretty deep in the woods) that have threatened the entirety of the European project. One particular issue that these previous economic crises highlighted was the fact that because (nearly all) EU member states share a currency, they also share a common monetary policy—which may not be appropriate for each country. The whole process has not been pretty to watch, and has caused many in Britain to question the EU leadership.

National Sovereignty

The EU is designed to help integrate its various member countries. This means setting (some) rules from a central body, rather than at the country level. A big part of the EU is the free movement of EU citizens among EU member states. This free movement policy meant that the UK was required to allow any EU citizen to immigrate to Britain. Because the UK has one of the strongest economies in the EU, a large number of people wanted to immigrate—especially from less prosperous countries.

Open borders have never been popular in the UK. Many felt that immigrants took jobs from British people and caused a drop in wages. However, because they were an EU member, the British government could not do anything to limit immigration from other EU states—it was part of membership in the EU.

However, there were other issues that caused the British people to feel that their sovereignty was being eroded. The most prominent of these issues was trade regulation. Because the EU promoted almost completely free trade among member states, trade regulations needed to be normalized between countries. This meant that the bureaucracy in Brussels was imposing a number of rules on British business, and many of those rules were very unpopular.

Eventually, discontent rose to the point that the current British government felt it needed to promise a referendum on leaving the EU to be re-elected during the 2015 elections (supposedly this was decided at a Pizzeria Uno in Chicago’s O’Hare airport). Throughout the Brexit campaign, the country had consistently been divided. And the results from Thursday night were very close – 52% for leaving the EU, and 48% for remaining in the EU. Definitely not a landslide, but still a victory for the Leave campaign.

So What Happens Now?

No one is entirely sure. There haven’t been any countries that have wanted to leave the EU before. Britain is better positioned to leave the EU than most countries as it never adopted the Euro, but it is unlikely that this will be an easy or quick process.

Once the UK formally notifies the EU that they wish to leave, a two-year window opens to negotiate the terms of the exit (or divorce, as everyone is inevitably calling it). The biggest issue will be free trade between the EU member states and the UK.

Access to the EU markets was one of the primary reasons that many in the UK wanted to remain as part of the EU. Now that the UK has left, British companies will likely not be able to access continental markets as freely (and vice versa—it’s unlikely companies in EU member countries will be able to access the UK market as freely as in the past either). This potential restriction of market access could potentially hit the UK economy pretty hard. The UK is an island nation, and they trade extensively with the rest of Europe.

Proponents of leaving the EU point out that Norway is not a member of the EU, but is able to (relatively) freely access EU markets. However, Norway has adopted many, though not all, of the EU’s regulations.

Another issue is that the EU is likely concerned about other countries leaving in the future, which means they may not be willing to go easy on the UK during the exit and trade negotiations.

All in all, no one really knows what to expect from here. And it will take a while for everything to play out.

What Should I Be Doing With My Investments?

You should be doing what you normally do—stay the course.

The most important thing to do is to not panic. We’ve seen some substantial market movements in the past couple of days, and it seems a fair bet that this volatility will continue for a while. The thing is, we don’t know which way those moves are going to go.

The markets didn’t like the UK deciding to leave the EU. There are significant economic advantages for both the UK and continental Europe being part of a common market. It would have been better for business if Britain remained as part of the EU.

The markets move on new information, and that includes actual events as well as what market participants estimate will happen in the future. And we certainly saw a quick reaction to the results of the referendum. If you look at a chart of the Pound/Dollar exchange rate (or the Euro/Dollar exchange rate), it’s pretty clear when the markets started to realize that the Leave campaign might actually win. In early trading, the FTSE 100 Index, which tracks the UK stock market, lost about 8.7% of it’s value from Thursday’s close.

Part of this drop was because the markets didn’t place a very high likelihood on the possibility of the UK deciding to leave. In fact, on Thursday the FTSE 100, the S&P 500 Index, and both the Pound and Euro were all up slightly. Positive movement is not what I would have expected the market to do if it thought there was a real chance that Britain would leave the EU. Because of this estimate, when the Leave campaign won, it was a serious shock.

But something interesting happened during Friday trading. While the FTSE 100 was down a little more than 1% on the day, it actually was rising throughout almost all of the day. In the first five minutes of trading the FTSE lost almost 7%. But from that point until closing, the index was up a little more than 6%.

This is a rapidly developing, and completely unprecedented, situation. There is almost assuredly going to be a lot of volatility going forward as everyone figures out what all of the implications are, and what the actual divorce will look like.

This is one of the times where your discipline is going to be tested. You need to stay focused on the long term, and trust in your asset allocation. Everyone is talking about the equity markets, but it’s unlikely that your portfolio is all equity. The bond portion of your portfolio is there to mitigate the amount of risk you are taking, and to keep everything on an even keel. It’s also worth noting that the Barclays Aggregate Bond Index, which measures the performance of the US bond market, was up about half a percent on Friday.

While it’s tempting to look at the situation and say that you want to get out and avoid the mess, trying to time the markets and guess which way they are going is a good way to lock in your losses. Since the markets react so quickly to new information, there’s no way to predict which way the market is going to move. But it’s likely they will be moving quickly, as we’re in uncharted territory here. And remember, when you are trying to time the market you need to be right twice—when you should get out, but also when you should get back in. Making a mistake on when to get back in can be extremely costly—historically, markets rebound quickly after a drop. Trying to avoid losing money often means that you cement your losses, but don’t have the opportunity to take the gains.

Going forward, what we wanted to see on Friday is that market mechanisms continued to operate effectively, and they did. Nothing has changed with our investment philosophy. Risk and return are still related. Markets are still pretty efficient (we just saw how fast they react to new information on Thursday night). The financial media are in full blown crisis mode right now, and while this is definitely a massive and historic story, your portfolio’s interests don’t line up with theirs. The financial media isn’t there to help you have a good investment experience. They are there to get you to watch the news. Talking up the end of the world is a good way to do that.

In the media, there’s always some reason that the markets are going to fall apart. Earlier this year it was China. Before that, we were worried that Greece might be forced to stop using the Euro. There’s always something going on, but through it all the markets keep trucking along—over the long term. (We actually have a whole ebook walking through how long-term investors have done well despite all of the bad things going on in the market). And that’s the key. By staying disciplined and focusing on the long term, you’re able to weather the day to day disruptions and position yourself to meet your financial goals and have a good investment experience.

If you have any questions about this, or anything else, you can always reach out to your advisor, or Contact McLean.

 

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