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Letter to Clients: 3rd Quarter 2016

“Democracy is the worst form of government, except for all the others” – Winston Churchill

“Economic freedom is … an indispensable means toward the achievement of political freedom” – Milton Friedman

“The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries.” – Winston Churchill

Dear Clients and Friends:

Like many of you, my family and I had a wonderful time celebrating the Fourth of July holiday weekend. When I was growing up, the Fourth seemed to be mostly about barbeques, friends, hanging out at the pool, and fireworks. Through my adult years, however, I’ve gained a better appreciation of what Independence Day really means. As Americans we have a degree of freedom that too few today, and even fewer throughout recorded history, have enjoyed. Our freedom came (and continues to come) at a steep price.

We have the freedom to speak our mind, the freedom of religion, the freedom to assemble, and the freedom to question our government. We also have the freedom to choose our own leaders – from the local city council to the President of the United States. The Presidential election process is well underway but many folks, from both ends of the spectrum, aren’t very enthusiastic about the remaining candidates.

While it may not always be perfect, if you really reflect on it, we, as a nation, govern ourselves. This grand experiment in democracy has been exported around the world, taking many different forms in the process.

Political tremors create economic waves

This leads us to Europe–and the United Kingdom in particular. On June 23, the UK voted in a nonbinding referendum to exit the 28-nation economic and political bloc called the European Union. Though “Brexit” was chosen by a narrow margin, the people have spoken. Since it is a nonbinding referendum, British lawmakers could choose to ignore the results. While there has been some talk that a UK exit will never happen, at this time it doesn’t seem likely the referendum will be ignored.

Nonetheless, a victory by the “Leave” camp wasn’t supposed to happen. While the vote was expected to be close, pollsters, analysts, and even the bookies who took bets all projected “Remain” would squeak through with a win. In advance of the vote, stocks rallied in anticipation “Leave” would be defeated. Good or bad, continuity usually benefits markets because it provides certainty.

Markets hate uncertainty. More accurately, short-term traders dislike uncertainty and are much quicker to hit the sell button than long term investors who tend to be more tolerant of disappointments. We find ourselves in uncharted waters. No nation has ever asked to leave the EU and there are too many unanswered questions. Could Brexit fuel other separatist movements and create additional economic uncertainty in Europe? Might we see the euro currency, which is shared by 19 nations, begin to unravel? What pressures might this put on an already fragile European banking system? Will the dollar begin to strengthen as global investors see the relative safety of the U.S. as a shelter from the stormy global environment?

While these are the longer-term concerns, there were a couple of immediate casualties. British Prime Minister David Cameron, who was adamantly opposed to Brexit, quickly resigned. The British pound fell to its lowest level in over 30 years. At home, expectations of a second rate hike by the Federal Reserve have dimmed considerably.

Brexit 101 – What it is all about

In some respects, the vote boiled down to economic uncertainty versus national sovereignty. The EU is both an economic and political union. Member countries enjoy the benefits of free trade, allowing goods and services to flow freely across national borders. Now that the UK appears poised to exit the EU, trade deals and the vast complexities of the exit must be negotiated.

Some larger companies which had set up shop in London and use that address as a gateway into the EU may now find other host countries to be more beneficial. This could spur layoffs and empty buildings which could dampen investment and consumer spending, leading to a recession in a worst case scenario.

Alternatively, membership has its costs and nations in the EU sometimes find themselves burdened by the whims of the European Parliament. Immigration was one of the biggest concerns facing UK voters, as member nations must accept anyone who is a citizen of the EU. It is this open-door immigration policy that has rubbed some folks the wrong way. Many Brits dislike EU rules which require British taxpayers to finance welfare benefits for those in need who immigrate to the UK.

In a nutshell, what voters viewed as onerous regulations and their impact on national sovereignty trumped the economic uncertainty a Brexit might cause.

Closer to Home

Many of the themes that have kept stocks prices high continued to play out over second quarter. U.S. economic growth appears to have accelerated in Q2 and interest rates remain low. While Brexit may muddy the picture, earnings are forecast to begin rising again in Q3. Increases in oil prices have not only reduced the strong headwinds in the troubled energy sector, but have reversed the surge in yields among high yield bonds. Yet, thankfully, a fill-up at the gas station still remains quite reasonable.

Moreover, the dollar’s recent stability reduces the drag on revenues from firms that do a significant amount of business overseas. When U.S. companies sell goods around the globe, they must translate those sales back into stronger dollars. A rising dollar is gift for Americans traveling overseas, but it puts a dent in the bottom line of multinationals.

Investor impact

Control what you can control – the investment plan – and be very careful about making a rash decision based on an emotional selloff. Stocks took a beating in the wake of the Brexit vote but quickly recovered nearly all of their losses by the end of June. Most investors don’t fully understand the impact of what just happened in Europe in relation to their own investments. Honestly, many analysts would concede there are unknowns.

One of our goals is to keep you focused on your financial goals and objectives. Emotionally based decisions will rarely work out in your favor.

You may recall that the last letter touched on how markets price stocks. Whether large or small, highly sophisticated or novice, investors price stocks through their collective buy and sell decisions. When new information is disseminated in the marketplace stocks react either positively or negatively depending on how the information is viewed.

By itself, the UK’s economy won’t send the U.S. economy into a recession. But Brexit creates a new level of uncertainty. However imperfectly, investors are attempting to discount the event pricing in how it may affect the U.S. economy and corporate profits.

Our approach is to take a longer term perspective and realize that, over time, growth and stability always overcome fluctuations and gyrations in the markets.


Source: Wall Street Journal, MSCI.com
MTD returns: Nov. 30, 2015–Dec. 31, 2015, 2015 returns: Dec. 31, 2014–Dec. 31, 2015
*Annualized **USD

Final Thoughts

Democracies can be messy. Our Presidential election and what happened in the UK are only a couple of examples.

While we do not know where the waves of populism that are swelling in the US and Europe will take us, they do represent the will of free citizens. Democratic freedoms enable the ordinary to do the extraordinary; to innovate, to create wealth, and to fuel new economic growth. True democratic elections aren’t always neat and tidy, but history strongly suggests they are a vital ingredient for long term economic success.

You have your financial goals; DV Financial has a plan to help achieve them. It is best to stick with your plan which includes understanding and managing your risks. We are here to serve you and I am honored and humbled that you have given me the opportunity to serve as your financial confidant and advisor.
If you ever have questions or concerns, or just want to talk, my team and I are available. Enjoy the rest of your summer!

Sincerely,

Art Dinkin, CFP®