(Tax loss) Harvest Season is Almost Here!

The kids are back in school, the leaves are changing colors, and pumpkin spice lattes – the age-old harbingers of harvest season – are everywhere. At Parsec, we are preparing for the harvest…of tax losses.

Every year, beginning in late October/early November, Parsec’s portfolio managers will scour clients’ taxable accounts for meaningful losses, which we can use to offset realized gains created from trading throughout the year. These tax-efficient trading strategies provide value to clients by minimizing their tax burden while keeping the portfolio aligned with their financial planning goals.

You might see trades from one security into another one that is similar, but not exactly the same – we do this so that you can recognize a loss while maintaining exposure to the same industry or sector, yet avoid incurring a wash sale. According to IRS publication 550, “a wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale, you buy substantially identical stock or securities,” either in the same account or in another household account, including IRAs and Roth IRAs. Stocks of different companies in the same industry are not considered “substantially identical,” nor are ETFs that track the same sector but are managed by different companies (like a Vanguard Emerging Markets ETF vs. an iShares Emerging Markets ETF).

Sometimes it makes sense to place a loss-harvesting trade and leave the proceeds in cash for 31 days, then repurchase the same security. We may do this for clients who have cash needs during the holiday season, with the intention of placing rebalancing trades in January when there is no more need for liquidity. When liquidity is not an issue, however, we prefer to keep the funds fully invested in another high-quality name. We may later choose to reverse the trade, once the wash sale period has expired, or we may leave the trade in place if we think it is appropriate and suits the clients’ needs.

Sarah DerGarabedian, CFA
Director of Portfolio Management

 

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What does a Weaker U.S. Dollar Mean for Companies & Consumers?

Earlier this year the U.S. dollar reached a 10-year high compared to the currencies of its major trading partners*.  However, the greenback has declined about 8% year-to-date through July.  In this email we’ll explore what drove the U.S. dollar to record levels, how dollar weakness or strength impacts corporations and consumers, and what may lie ahead for the world’s most widely-held currency.

Many factors affect a currency’s strength or weakness.  Some of these include interest rate levels, inflation, central bank policy, investor sentiment and the health of the economy.  The U.S. dollar is unique in that it is the largest foreign exchange reserve, accounting for over 60% of global reserves.  As a result, other countries’ need for reserves and investors’ fears or confidence also affect how much the dollar appreciates or depreciates.

Following the financial crisis, the U.S. dollar appreciated versus many other currencies due to its perceived safety and ultimately, a quicker U.S. economic recovery compared to its peers.  This happened despite the Federal Reserve’s ultra-accommodative monetary policy in which it pumped trillions of dollars into the economy – an action that might normally depreciate the dollar due to an increased currency supply.  Instead, the Fed’s actions helped lead the U.S. economy out of the financial crisis which helped support corporate earnings and sales growth.  This in turn led to increased foreign demand for U.S. stocks and bonds.  As U.S. dollars are required to purchase our stocks and bonds, growing foreign investment in U.S. securities led to greater demand for the greenback, and subsequent dollar appreciation.

During the last ten years of dollar appreciation, we’ve experienced both positive and negative effects.  On the positive side, a strong dollar makes traveling abroad more affordable for U.S. citizens and effectively lowers the prices consumers pay for imports.  As consumers account for roughly two-thirds of U.S. GDP growth, the savings gained on lower-cost imports due to a strong dollar can lead to significant gains in disposable income, all else being equal.

On the downside, a strong dollar may hinder tourism in the U.S. and could result in weakened demand for U.S. exports as those goods become relatively more expensive for foreigners.  Another drawback is negative foreign currency translation for U.S. multinational companies.  U.S.-based firms that earn revenues abroad will have to exchange foreign currencies back to U.S. dollars at a less favorable rate.  This acts as a headwind to sales and earnings growth, and contributed to the recent “earnings recession” we saw among companies in the S&P 500 Index in 2015 and 2016.

In contrast, recent U.S. dollar weakness has started to help boost corporate earnings growth and could be a support for stocks going forward.  While it’s impossible to know if the dollar’s strength will continue to moderate, a few factors suggest it might.  One is an improving global economic outlook relative to the U.S.  The U.S. economy was a bright spot in the early years following the last recession, but emerging market economic growth is gaining ground and European GDP growth recently outpaced U.S. GDP growth.  Another factor is that the Federal Reserve has shifted to a less accommodative monetary policy stance.  Ordinarily this would support further U.S. dollar appreciation (via a reduced supply of dollars and higher interest rates attracting foreign investors); however, investor concerns that restrictive monetary policy could slow down the current economic expansion are outweighing the shift in the Fed’s policy stance.

Considering the above factors and given several years of strong gains, recent U.S. dollar weakness could continue.  While there are pros and cons to a depreciating dollar, we would welcome the shift as this would help reduce import costs for consumers and businesses, while supporting sales and earnings growth for U.S. multi-national corporations.

*Powershares DB US Dollar Index Bullish Fund (UUP) – compares US dollar to euro, yen, pound, loonie, Swedish krona and Swiss franc

The Parsec Team

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Value Stocks May be Poised to Outperform

Since Parsec’s founding in 1980, we’ve touted the benefits of long-only equity investing.  This includes owning individual stocks, mutual funds, and exchange traded funds (ETFs).  We’ve also maintained the same investment style over the last thirty-seven years.  Regarding funds, Parsec’s investment policy committee (IPC) focuses on low fees, higher-quality holdings, and managers with long track records of outperformance.  When researching individual stocks, we take a value approach, favoring higher-quality companies that trade at a discount to history or peers.

While history shows that value stocks have outperformed growth stocks over most market periods, in recent years growth stocks have delivered higher returns.  In this email we’ll discuss what we mean by value versus growth investing and why we believe value stocks are poised to outperform going forward.

Different stock investors define “value investing” differently.  However, most agree on a few basic principles.  In general, value investors prefer stocks that trade at discounts to their intrinsic values.  Often this happens when a stock’s valuation falls below its long-term historical average or that of its peers.  Another tenet of value investing is margin of safety.  This means selecting stocks that can deliver healthy total returns even if current growth assumptions fall short of expectations.  While we consider ourselves value investors, we will add select growth stocks to the Parsec buy list when expectations look reasonable and a company has a competitive advantage.  In other words, when we think a stock has a reasonable margin of safety.

In addition to a value-based stock selection approach, Parsec’s investment philosophy also has a quality bias.  This means we prefer companies with strong cash flows, consistent earnings growth, a long history of dividends, and above average returns on invested capital.  We also favor companies with strong balance sheets that can withstand different market environments and even gain market share during difficult economic periods.

Looking back over the market’s history, value stocks have outperformed growth stocks by an average of 4.4% annually from 1926 to 2016 (Bank of America/Merrill Lynch).  More recently from 1990 to 2015, value stocks outperformed growth stocks by just 0.43% annually.  The spread has since reversed and in the last ten years value stocks have lagged growth stocks by 3% annually through the second quarter of 2017*.

The shift in leadership from value to growth stocks coincided with the start and continuation of the Federal Reserve’s massive monetary accommodation programs known collectively as quantitative easing (QE I, II, and III).  Those programs put additional downward pressure on interest rates.  In the face of low or no yields and the slowest economic expansion after a deep recession in over 120 years, investors demonstrated a preference for growth stocks over value stocks.  They were willing to pay up for companies delivering higher growth in a world where growth had become scarce.  Throughout the last ten years value stocks have occasionally outperformed, but usually in tandem with a steepening Treasury yield curve and thus improving growth expectations.

Because asset prices and interest rates are inversely correlated, very low interest rates over the last decade have led to above-average asset valuation levels.  This has been even more pronounced among growth stocks as investors have been willing to pay a premium to own them in a slow growth environment.  As a result, typically higher-priced growth stocks are even more expensive today.

Sticking to our value- and quality-biased investment approach has admittedly been a headwind in recent years.  However, we believe higher-quality stocks trading at a discount are poised to outperform.  Growth stocks currently trading at premium valuation levels will have further to fall in the event of a market downturn.  As well, low interest rates have prompted corporations to take out record debt levels.  As rates begin to rise, higher-quality companies or those with strong balance sheets and robust cash flows will be better able to service their debt levels, even during an economic downturn.  While maintaining our investment approach through the current environment has been challenging, we feel confident that investing in higher-quality companies trading at discounted valuations will reward clients over the long-term.

*References the Russell 3000 Growth Index and the Russell 3000 Value Index

The Parsec Team

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Mid-Year Market Update

Now that we’re half-way through 2017, it’s time to take a look at market and economic trends year-to-date. The big picture view is that asset classes across the board have delivered strong returns through June. This is despite interest rate hikes by the Federal Reserve’s Federal Open Market Committee (FOMC). In fact, Treasury yields have actually fallen in the face of two interest rate increases this year, pushing bond prices higher. International stocks and bonds have also risen in 2017, boosted by stabilizing global growth rates, depressed yields world-wide, and improving corporate earnings.

Looking a little more closely at the U.S., stocks continued their upward trajectory early in the year following the post-Presidential election results in November. While the new administration has not made much traction in passing new legislation, relatively healthy economic data – including good jobs growth, higher wages, and a strong housing market – have supported stocks. At the time of this writing (June 15, 2017), the S&P 500 Index is up 8.5% on a price-basis and up 9.7% on a total return basis (which includes dividends).

Technology stocks have led U.S. equity markets this year. Within the S&P 500 Index, the sector is up over 17% year-to-date given healthy earnings growth expectations for the group. The more tech-heavy NASDAQ Index is up a whopping 14% this year, almost 6% ahead of the S&P 500 Index. However, we’ve started to see some signs of weakness among tech stalwarts recently and are watching the group closely. On the flip side, energy and telecom stocks have lagged the index, with price declines of 13% and 9%, respectively. Of note, energy and telecom stocks were two of the three best-performing sectors in the S&P 500 Index last year, with prices returns of +24% and +18%, respectively. This marked turnaround in performance provides a cautionary tale on the pitfalls of market timing: last year’s leaders may well become this year’s laggards. In general we’ve found that it’s difficult, if not impossible to predict which sectors or industries will outperform in any given year. As a result, we recommend maintaining a diversified portfolio through all market cycles and rebalancing regularly.

Another wide disparity arose among growth and value stocks. Year-to-date, growth stocks (as measured by the Russell 3000 Growth Index) are up almost 14% on a price return basis versus a 3% return for value stocks (as measured by the Russell 3000 Value Index). Much of the outperformance by growth stocks stems from strong returns among technology stocks – many of which are growth-oriented and trade at higher valuation levels.

After years of underperforming U.S. stocks, international equities have outperformed year-to-date. In aggregate, developed stocks from Japan, Europe, and Australia are up 14% on a price return basis through June. While this group has lagged U.S. stocks over the past four consecutive years, improving economies in most of these regions, positive consumer sentiment, and accommodative central banks are starting to turn the tide. Likewise, Emerging Markets stocks are up over 17% on a price return basis so far this year. The marked turnaround comes as corporate earnings growth for many of these countries is starting to improve and global growth is stabilizing.

Other interesting observations for 2017 include record-low stock volatility levels, lower yields despite higher interest rates by the FOMC, and an eventful (if unproductive) six-months in Washington.

Looking forward, we see risks and opportunities. The Federal Reserve is set to reduce its bloated balance sheet later this year which could pose a risk to above-average stock valuation levels. Despite the potential for unintended consequences, we view the move as a vote of confidence in the U.S. economy and as a much needed step towards more normalized monetary policy. While a more restrictive Federal Reserve is a headwind to asset prices, interest rates remain very low (with no signs of rising) and the U.S. economy remains on stable footing. These factors, along with improving U.S. corporate earnings growth, bode well for continued stock gains over the long-term.

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The Perfect Gift? Ideas…From a Planning Perspective

December is here and 2016 is drawing to a close.  As we enter the holiday season, we scramble to pick the perfect gift for our family members, our friends, teachers… the list goes on.

At Parsec, we work with clients to create gifting strategies that fit into their overall financial plan.

This December we encourage you to think about giving and its potential longer term impact on both your family (children and grandchildren) and your taxes.  Let’s first review a powerful gifting strategy to younger family members: the custodial Roth IRA.

As long as there is earned income, which can come from mowing lawns, housework, babysitting etc., contributions to a custodial Roth IRA can be made up to the amount of the earned income but not over $5,500*.  For example, your 9 year old grandchild earned $1,000 over the summer through his lawn mowing business.  You can open a custodial Roth IRA for him and deposit a matching gift of $1,000. Let’s say he continues to mow lawns each summer for the next 10 years and you continue to match his earnings with a $1,000 holiday gift.  Assuming a 7% return each year, your gifts will grow to over $15,000 at the end of 10 years.  Remember this is only the beginning, the approximate $5,000 earnings in this example will continue to compound over time and ALL earnings are tax free upon withdrawal later in life.  Rewarding your grandchild’s hard work through Roth contributions is a holiday gift that offers valuable lessons on many levels.

Let’s switch gears to philanthropy.  Each year Parsec’s client service team processes hundreds of charitable gift requests from our clients.  These gifts of course offer tax advantages in various forms.  For many of our clients, the qualified charitable distribution or QCD brings the most formidable tax savings.  How does it work?  If you are over 70 1/2, up to $100,000 of your required minimum distribution (RMD) can be given directly to charity through a QCD.  The result: your AGI will be reduced dollar for dollar by the amount of the QCD.  A simple, yet impactful strategy:  on not only your charity of choice but also on your tax dollar.

As we enter this holiday season we hope that you reach out to your financial advisor to talk about gifting strategies that may be appropriate for you and your family.  Happy Holidays!

Betsy Cunagin, CFP®

Senior Financial Advisor

*$5,500 is the IRA contribution limit for 2016 and 2017.  

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10 ways to celebrate Independence Day:

Visit a historical site:

Western North Carolina is rich in history. One of my family’s favorite locations is Cherokee. In particular, we like to visit the Oconaluftee Indian Village. We always enjoy walking the trials and making new friends. Staff members are eager to share stories and have live demonstrations on how the early Cherokee people made jewelry, clothes, weapons, shelters, and canoes. We always seem to learn something on our trip back through time.

Read the Declaration of Independence

While many of us can recant passages of the document such as, “We hold these truths to be self evident,” how many of us have read or can recall the 27 grievances in the original writing leading to the declaration?

Get active – go for a hike, fishing, or camping:

Did you know that WNC has some of the arguably best trout fishing in the state? We have well over 3,000 miles of trout streams and each year the Wildlife Commission closes 1,000 miles for restocking and delayed harvesting. Currently, fishing season is wide open with a 7 daily keeper limit.

Make it memorable:

Consider investing in a decent photo or video camera. We took the plunge a few years ago and bought both types of cameras. We have a lot of fun capturing memories. Occasionally, we will look back on these priceless photos and videos to relive the moment and found this to be a great pass time. One of the things I like to do is compile short video clips and then set them to music; this makes a great way of preserving memories in a fun and engaging way.

Pack a picnic and watch the fireworks:

Admit it, many reading this cannot recall the last time they sat on a blanket and enjoyed a picnic dinner. How about trying a new recipe or pick up a box of fried chicken while picking out the perfect viewing area? Don’t forget to pack a frisbee to toss around. Looking for fireworks? Find them here!

Treat a veteran to lunch or dinner:

What better way to honor our nation’s heroes by treating them to a lunch? We see active duty servicemen and women at restaurants near the Asheville airport. Something we like to do is anonymously pay for their meal.

Make a difference:

Everyone has something they are passionate about. Why not take this passion and introduce it to someone new? For instance, an outgoing person might go to a nursing home and visit a resident. Someone who enjoys soccer could visit a local park and start a pick-up game.

Throw an Independence Day themed BBQ:

On a recent visit, the client arranged for a catered Low Country Boil as incentive for his staff to stay after hours for my education presentation and one-on-one meetings. This was my first boil and I was impressed at the simplicity of the food and great conversations. So much so, this inspired my family to invite a few good friends over for our first boil this summer! (If any have advice about how to make this go off without a hitch, please email me with your thoughts and suggestions.)

Watch the local 4th of July parade:

Remember when you were a kid and watched the parade? The nostalgia of candied apples, popcorn, marching bands, and waving the American flag just oozes fun and happy memories! It just doesn’t get much better.

Declare your independence, financially that is:

The Declaration of Independence is roughly 1,400 words. Financial independence does not require a formal “declaration” per se, but it does require a well thought out plan.   Just as our forefathers were resolute in their desire for independence, our decision to save and invest for our future should be a high priority. Things that should be considered are having adequate cash reserves, health, life and disability insurance, long-term savings and investments, and estate planning documents to name a few. The internet has a wide variety of tools and resources that may be helpful. However, the advisors at Parsec take a unique and tailored approach for client recommendations and advice. More importantly, our advice is consistent whereas information on the internet will vary. Our belief is that with proper savings, planning, and investment oversight most people can achieve financial independence. If you have questions or concerns that you would like us to address, please call or write.

I hope everyone has a happy and safe 4th of July!

Neal Nolan, CFP®, AIF®
Senior Financial Advisor
Director of ERISA Services

Neal

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Implications for “Brexit”

Investors received surprising news this morning, as the United Kingdom (U.K.) voted to leave the European Union (EU).  While markets will no doubt experience increased volatility in the coming weeks, longer-term, we believe the negative impact of “Brexit” will be largely contained to Great Britain and Europe.

Trade accounts for about 40% of the U.K.’s gross domestic product (GDP), with most of those exports and imports tied to EU partners.  As a result of the recent vote, Britain is likely to see higher trade tariffs from the EU and more trade staying within continental Europe’s borders.  Both of these shifts could weigh significantly on Britain’s economic growth in the mid-term and would likely weigh on EU growth as well.  One positive is that the U.K. never adopted the Euro, choosing instead to maintain the British Pound as its currency.  This is should make an exit from the EU smoother and slightly less costly than if they had converted to the Euro, and suggests it could be less detrimental than if Greece had left.

While the U.K. is likely to experience the largest negative impact by leaving the EU, continental Europe is also at risk given its relatively fragile economic expansion following the Financial Crisis of 2008-2009.  From 2010 through 2015, EU GDP has grown at an average rate of just 1.2% compared to U.K. GDP growth of 2.0%.  Thus any major shock, such as one of its strongest members leaving the Block, could derail those modest growth levels.

Turning to the U.S., Europe is one of our larger trade partners with about 16% of total U.S. exports going to the Block last year.  This is not an insignificant number, and will likely weigh on U.S. GDP growth in the near-term.  However, the U.S. consumer remains the largest driver of our economy, accounting for about two-thirds of GDP growth.  Following the Financial Crisis of 2008-2009, the U.S. consumer has gotten healthier, supported by an expanding housing market, strong jobs growth, and deleveraging.  A resilient consumer and relatively better economic growth compared to the rest of the world should position us to better weather the recent developments in Europe.

To be sure, today’s news surprised investors and markets alike.  Although the near-term economic impact will likely be limited to the U.K. and Europe, the vote has broader implications for the future of the European Union.  While we can’t predict the longer-term repercussions of today’s historical vote, we can assure you of the benefits of staying invested in a diversified portfolio over the long-term.  Markets will experience sharp corrections, as well as strong rallies, yet clients who remain invested across asset classes throughout the market cycle have a better chance of reaching their financial goals.  With this perspective in mind, market declines like the one we’re seeing today simply represent an excellent opportunity to rebalance your portfolio at more attractive valuations levels.

 

Thank you,

The Parsec Team

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Things are not as bad as the media would have you believe

Queen Elizabeth II turned ninety years old on April 21st.  While I don’t follow the Royal Family all that closely, I do love Princess Kate’s fashion sense and have a thing for sparkly tiara’s (the real ones).  So naturally when I saw an article about the Queen’s birthday I had to check it out.  In addition to some great shots of the Crown Jewels, I found one of the Queen’s comments particularly uplifting.  When asked about the state of the world, Elizabeth unequivocally said that things are much better today than when she was a child.  Although recent headlines – from terrorist attacks to slowing global growth – would have us believe otherwise, I’d like to provide some much-needed evidence that we’re living in pretty good times.

First, Americans are living longer and are healthier than ever before in history.  In 1800 the U.S. life expectancy was 39 years at birth, then 49 years in 1900, 68 years in 1950, and an incredible 79 years today!  In addition to a longer life expectancy, we can take advantage of our twilight years with something called retirement.  The concept didn’t exist in the U.S. prior to the late 1880’s, when workers pretty much labored until they died.  That started to change in 1875 when American Express offered America’s first employer-provided retirement plan.  The Federal Government followed suite in 1935 with the creation of Social Security; and medical health benefits for those over 65 years, also known as Medicare, started in 1965.

According to the Federal Reserve, the number of years spent in leisure – measured as retirement plus time off during your working years – rose from 11 years in 1870 to 35 years by 1990.  While we’re not all experiencing a Downton Abbey lifestyle, things could be worse.

Concerning crime and violence: while the tragic terrorist attacks in recent years are difficult to reconcile, overall murder rates in the U.S. have dropped dramatically since the 1990’s.  America averaged 20,919 murders during that decade but the average number of murders in the 2000’s dropped to 16,211.  On a global level, a report from the Human Security Report Project suggests the world is getting safer, as it relates to people killing other people.  Deaths from war has been in decline since the end of World War II and high-intensity conflicts have declined by more than half since the end of the Cold War.  The report goes on to say that terrorism, genocide, and homicide numbers are also down.

Americans often worry that slowing U.S. growth and rising debt levels will result in a downward economic spiral.  They often point to Japan as a worst-case-scenario.  While the island nation has its challenges, consider that Japanese unemployment has remained below 5.7% for the last 25 years, income per capita adjusted for purchasing power continues to grow at a healthy rate, and life expectancy is on the rise.  Plus I hear they have amazing sushi.  I can think of worse outcomes.

Another common concern I read about is stagnant wage growth.  While I believe this is an important issue, consider that the median annual household income adjusted for inflation was about $25,000 in the 1950’s.  Today it’s almost double that!

A few other things that are better: U.S. death rate from strokes has declined by 75% since the 1960s; deaths from heart attacks have also dropped dramatically; more Americans attend college today than at any other time in our history; smoking is down sharply; poverty is on the decline in the U.S.; and fewer people around the world die from famine each year.

Happily, I could go on, but I won’t.  Suffice it to say that Queen Elizabeth II, in her 90 years of experience and wisdom, may be right.  And even if she’s not, we’re all better off believing she is.

Carrie A. Tallman, CFA
Director of Research

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What is Smart Beta?

You’ve undoubtedly heard this term, used to describe a certain type of investment that is becoming increasingly popular. What does it mean? And if these investments are “smart,” does that mean that the others are “dumb?”

So-called “smart beta” investing is a bit of an active/passive hybrid methodology. Traditional passive investments are typically replicas of well-known market capitalization-weighted indices, like the S&P 500. A market cap-weighted ETF holds each company in the index according to its size in the index, which can be calculated by multiplying a company’s outstanding shares by the current market price of one share. While this provides broad market diversification at a very low cost, one drawback of this approach is that the companies whose stock prices are rising become relatively larger while companies whose stock prices are falling become relatively smaller. If markets are less than perfectly efficient and stock prices are anything other than fairly valued, cap-weighted indices will tend to favor overvalued companies.

“Smart beta” strategies use different weighting schemes to construct a portfolio, involving metrics such as dividends or low volatility, or even equal-weighting, all of which sever the link between price and weight and tend to provide a value tilt to the portfolio. The reason for this is that, when rebalancing the portfolio, these strategies result in buying low and selling high. Portfolios based on market cap-weighted indices will often do the opposite when rebalancing, buying more shares of the companies whose stock prices are going up, and vice-versa. According to Research Affiliates, LLC, “smart beta” strategies must also encompass the best attributes of passive investing, such as transparency, rules-based methodology, low costs, liquidity, and diversification.

Does this mean that “smart beta” is a panacea that will bridge the gap between active and passive investing? Many of these strategies have back-tested well and have become increasingly popular, resulting in large inflows of capital. Rob Arnott, one of the pioneers of smart beta at Research Affiliates, has written about rising valuations in smart beta investments as a result of their soaring popularity (“How Can “Smart Beta” Go Horribly Wrong?”). He cautions against “being duped by historical returns” and advises investors to adjust their expectations for future returns to account for mean reversion. He and his co-authors think there is a possibility of a smart beta bubble in the works, due to the rising popularity of such strategies.

And what about traditional passive investments? Is there still room for these vehicles in an investor’s portfolio? Absolutely, particularly in the more efficient sectors of the broad market.  Even Arnott believes “there is nothing “dumb” about cap-weighted indexing.” At Parsec, we stay abreast of current investment trends, but use a measured approach to portfolio construction that is research-based and backed by sound financial theory. We don’t believe any one investment is particularly “smart” or “dumb,” but rather that there is room for different types of investments within the context of a well-diversified, well-constructed portfolio.

Sarah DerGarabedian, CFA
Director of Portfolio Management

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Brexit: What is it and what are the investment implications?

There have been many headlines recently about the so-called “Brexit”, or the possibility of the United Kingdom leaving the European Union. There is a referendum on the subject coming up on June 23 in the UK, with current polls showing 47% in favor of staying and 40% in favor of leaving. This is not to be confused with the “Grexit” fears from a few years ago about the possibility of Greece leaving the European Union as well as the Euro currency. The UK is different in that it is a member of the EU, but continues to use the Pound as its currency rather than the Euro. Therefore, the UK maintains its own central bank and monetary policy. The main effect of such an exit has to do with trade agreements within the EU.

Potential negatives of an exit include a possible slowdown in the UK economy, short-term local stock market volatility and\or depreciation in the Pound. The EU represents about 50% of UK exports but only about 10% of imports, so if trade agreements are less favorable as a result of the exit then the UK stands to lose.

There are also positive factors to consider with regard to the UK. According to Goldman Sachs, the economy (as measured by Gross Domestic Product) in the UK is projected to grow faster than that of the US or the other Euro area countries in both 2016 and 2017. The Pound has already fallen 9% against the dollar over the past year, and the UK stock market has underperformed both the S&P 500 and the MSCI EAFE index over the same period. A vote to remain in the EU would remove the current uncertainty, and could be a catalyst for UK stocks to reverse their recent underperformance. If the vote is to leave the EU, many trade agreements will need to be renegotiated. This process will likely take years to complete, while UK stock market volatility should be short-lived.

To quantify our clients’ potential exposure to the UK, in a typical portfolio our target weighting for international stocks is about 26% of the overall allocation to equities. Of this amount, approximately 1/3 is emerging markets and about 2/3 developed markets. The UK is considered a developed market, and makes up about 20% of the MSCI EAFE index, which is the primary benchmark for most actively managed developed international mutual funds. This would imply that roughly 3-4% of our typical stock portfolio has exposure to UK equities through mutual funds, plus any additional exposure through individual stocks we might buy that are headquartered in the UK.

Since the outcome of the Brexit vote is impossible to predict with certainty, portfolio exposure to UK stocks is low and the effect of the vote on stock prices is indeterminate, we are maintaining our current target weights in international stocks.

From a diversification standpoint, investing in international stocks reduces overall portfolio risk since foreign stocks do not move exactly in tandem with US stocks. Sometimes international investing improves portfolio returns and sometimes it does not. In recent years international stocks have underperformed relative to the US, but historically there have also been periods of significant outperformance. While there will be more hype and headlines as the June 23 vote approaches, we remain committed to long-term investing in a globally diversified portfolio.

William S. Hansen, CFA
President
Chief Investment Officer

Bill

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