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Views on Brexit

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 Views on Brexit

An Interim Commentary From Wasatch Funds 

June 24, 2016

Overview 

  • Britain voted 52% to exit the European Union in a move commonly referred to as “Brexit.”  Prime Minister David Cameron has resigned, which creates political uncertainty.
  • We did not expect the Brexit vote to pass, and neither did the market (hence the volatility).  But we have been prepared for this potential scenario.  We reduced our U.K. exposure earlier this year as a risk-control measure due to Brexit-related uncertainties.
  • There continue to be many challenges.  So this overhang will take time to work through, and there is no playbook that can give guidance as to all the possible ramifications of the situation.  It is critical to keep short-term volatility in context and not allow such fluctuations to affect long-term thinking.
  • With external shocks such as this, one must weigh the evidence and determine if there will be a sustained or permanent impact on the value of the businesses we own.  For the most part, we believe the answer is “no” and we had already analyzed this as a potential scenario before the actual vote.
  • In the long term (three to five years), we believe the impact will be less significant than current forecasts predict.  The global economy periodically goes through dislocations—major ones (Global Financial Crisis, tech bubble, 9/11, Asian financial crisis, and war in the Middle East) and minor ones (Greece, Russia, and Long Term Capital Management).  Great companies adapt and evolve.  Remember, we own what we think are high-quality companies with strong balance sheets that can grow from cycle to cycle.  These companies tend to get stronger during the type of downturn that we’re seeing with Brexit.
  • We believe the impact to the U.K. and Europe will be the most significant, and the risk is elevated.
  • The U.K. will likely enter a recession, the Bank of England will try to stimulate, and the currency will not only be hit hard but will continue to be volatile.  Political uncertainty will weigh as Prime Minister Cameron has resigned and any Brexit negotiations are likely to take at least a couple of years to work through.  Business and consumer confidence are also likely to decline along with difficulty in accessing and deploying capital.
  • We believe one of the hardest-hit sectors will be financial services given London’s banking base and financial hub for Europe.  This will likely have follow-on effects and impact things like housing.  We still don’t know if the banking base will move.  But if it does, there will likely be beneficiaries—perhaps Switzerland and Germany.
  • Europe will likely have more uncertainty in the short and medium term.  The questions are already beginning regarding whether other countries want to leave the European Union.  Politicians in Holland and France have already called for exit referendums.  But their appetite for exit may depend on how the U.K. negotiations go.  In addition, both France and Italy have elections in the next year.
  • Within the context of Europe, we believe the U.K. is well-positioned and should be a relative outperformer in the medium to long term.  The reality is the U.K. is populated with high-quality companies.  The U.K. has its own currency, has relatively low regulation, and is clearly a democratic country with an innovative and entrepreneurial society.  For example, there have been 116 IPOs in the last two years.  In addition, U.K. companies were inexpensive relative to history (even before the vote), so they are even more inexpensive now.
  • We may be entering a longer “risk-off” environment and a flight to safety that could affect emerging markets.  The global markets have become narrower.  Some of the weak-commodity beneficiaries in emerging markets where growth is present have become incrementally more attractive (e.g., India and the Philippines).

Currency 

  • The most significant and perhaps most long-lasting effect will be on currency.  Foreign direct investment may grind to a halt, and uncertainty may persist for some time.  The Bank of England may try to stimulate.  And currency volatility is likely to continue.
  • In addition to some positive currency effects discussed in the section above, another medium-term positive is that a weak currency makes U.K. businesses attractive to foreign buyers.  And as discussed previously, the U.K. is home to many high-quality, global-leading companies. 

Additional Background

  • There’s still a chance Brexit will not occur, although that’s unlikely.  Technically, the vote was not binding on parliament so the government has veto power.  Also, there’s a chance that the U.K. will try for another referendum in the future (this has happened in Ireland) when voters see the negative implications of Brexit.
  • Negotiations can take up to two years under Article 50 of the Treaty of Lisbon.  This means uncertainty will persist.
  • The U.K. has weaker bargaining power by not being part of the European Union as it now needs to negotiate all the terms as an “outsider.”
  • The biggest impact is likely to be on London’s financial district.
  • London’s property “bubble” may deflate.  The influx of jobs, people and capital is more likely to reverse.
  • In terms of broader contagion, the U.K. represents 2% of global GDP.  The implications are bigger for countries closer to the epicenter of the crisis and for countries with significant economic ties.
  • The European Union is more important to the U.K. than vice-versa.  The EU accounts for 45% of all exports.
  • If the U.K. leaves the European Union, 50 or more trade deals will lapse because these deals were negotiated as part of the EU.

As always, we continue to focus our research efforts on deep due diligence regarding our investment thesis for each company.  The level of conviction we have in our portfolio companies remains extremely high.  These are companies that have executed well in the past, and our experience tells us that great companies have the potential to evolve and become even better companies in the future.

 

In addition to the risks of investing in foreign securities in general, the risks of investing in the securities of companies domiciled in frontier and emerging-market countries include increased political or social instability, economies based on only a few industries, unstable currencies, runaway inflation, highly volatile securities markets, unpredictable shifts in policies relating to foreign investments, lack of protection for investors against parties that fail to complete transactions, and the potential for government seizure of assets or nationalization of companies.

Investing in small cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds. 

An investor should consider investment objectives, risks, charges, and expenses carefully before investing.  To obtain a prospectus, containing this and other information, visit www.WasatchFunds.com or call 800.551.1700.  Please read it carefully before investing.

 

Definitions:

Gross domestic product (GDP) is a basic measure of a country’s economic performance, and is the market value of all final goods and services made within the borders of a country in a year. 

The Treaty of Lisbon is an international agreement which amends the two treaties which form the constitutional basis of the European Union (EU).

Information in this document regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this document.  These statements should not be relied upon for any other purpose.  Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.

ALPS Distributors, Inc. is not affiliated with Wasatch Advisors. 

© 2016 Wasatch Funds.  All rights reserved.  Wasatch Funds are distributed by ALPS Distributors, Inc.