July 14, 2016
Excerpted from a letter sent to clients on July 12, 2016.

The post-"Brexit" panic seems to have fizzled out almost as quickly as it came on: global stock markets are now higher than the day before the UK voted to leave the European Union.1

In our last letter, sent the day after the Brexit vote, we discussed the futility of trying to time markets based on economic or political events. The behavior of the markets over these last two weeks — a steep decline on a geopolitical news event, followed almost immediately by a full recovery — could hardly have provided better support for this view.

It's entirely possible (though far from certain!) there will be more Brexit-related market shocks to come. If there are, we will act as we did during this most recent episode: staying focused on the long-term value of what we own, and trying to take advantage of the opportunities afforded by market panics and volatility.

With that said, here are some brief thoughts on Brexit's impact.

Potential Economic and Market Consequences
There are reports that many UK "Leave" voters regret their votes, and some speculate that Brexit may not happen any time soon… or maybe even not at all.2 But the consensus view for now is that it will go forward in some shape or form, and that it will be a negative factor for the UK economy. Here are some of the major issues:
  • Exports to the EU account for 13% of UK GDP, so less favorable trade terms could have a significant impact.2
  • The future of the financial sector — almost 7% of UK GDP3 — has come into question as much of the sector depends on economic integration with the EU.
  • Scotland, which voted heavily in favor of remaining in the EU, may end up launching another referendum on its own independence. (Interestingly, some view this as a means by which Brexit might be blocked or sent back for a second referendum).4
  • Generally, uncertainty is bad for business investment, and the vote has led to an awful lot of uncertainty.
Exports to the UK only account for 3% of the European Union's GDP5, so the direct impact on the EU is likely to be significantly smaller than on the UK. The larger concern for the EU is the possibility that other EU countries might hold their own exit referenda. But that outcome may depend a lot on future circumstances, including what reaction the EU policymakers have to Brexit, whether they are moved to implement needed reforms, and how the UK fares after it exits (assuming it exits at all!).

We'd expect even less direct economic impact on the global economy as a whole. The UK accounts for less than 4% of world GDP, so it just doesn't have the same impact as countries like the US or China. It doesn't seem likely that Brexit will alter long-term global growth in any meaningful way.

Investors love to focus on big news events like this. And Brexit really is a major headline event, as these things go. But like all such events, it is just one crosscurrent in the ocean of factors that affect markets. The wild round-trip response to the Brexit vote shows that there's no predicting how a single factor like this will impact market returns overall. This is why we recommend downplaying the headlines and staying focused on valuations (which do help to predict returns6).

1 Source: stockcharts.com, Vanguard Total World Stock ETF (VT)
2 Source: Reuters
3 Source: Franklin-Templeton
4 Source: Franklin-Templeton
5 Source: The Economist
6 Source: Pacific Capital Associates