Beyond Bulls & Bears


The Post-Brexit Irrationality of Markets

Few markets had priced in the prospect of a Brexit vote in the United Kingdom’s European Union Referendum, which means that much of the immediate activity was indiscriminate. In these situations, according to Robert Mazzuoli, portfolio manager, Franklin Local Asset Management, European Equities, the dust often settles quickly, but there may be opportunities to find bargains among the most affected sectors.

Opportunities from Brexit

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The United Kingdom’s vote to leave the European Union (EU) took the markets by surprise. In the lead-up to the ”Brexit” vote, markets had increasingly priced in a decision to remain. The result therefore was initially greeted with panic in the market, but by mid-morning in the United Kingdom the situation appeared to have settled down a bit, with more liquidity in the market.

Investors are now mulling over what this decision might mean for the UK economy and that of Europe as a whole. Without question, this decision creates uncertainty because there is no blueprint for a country to leave the EU. That means the United Kingdom likely faces several years of negotiations before it leaves. That process needs to be conducted in an orderly manner; new treaties will need to be established between the United Kingdom and EU. The negotiations will likely take time and create uncertainty because no one really knows what the outcome will look like.

Political uncertainties abound. There will be a new UK prime minister in the autumn. Meanwhile, questions have emerged about the cohesion of the United Kingdom, including the possibility of a second Scottish independence vote.

And it’s a similar story of uncertainty in mainland Europe. Will other EU member states consider holding referendums?

Uncertainty is never good for an economy because it erodes confidence. Companies may postpone investment plans, consumers may postpone certain large expenses because they are uncertain whether their jobs are safe. We may see a slowdown in economic activity across the continent, and, that would certainly not be good news for the markets.

As we’ve occasionally seen in the past, today’s experience shows that the market sometimes acts in an irrational way. It does not punish only those assets that seem to be most directly impacted or tied to a particular event. During today’s European trading session we saw other markets across Europe that were actually impacted much more than the markets in the United Kingdom.

In these situations, we, as stock-pickers, try to seize certain opportunities in the market when we believe there’s been indiscriminate selling.

Today, for example, the highest-beta1 stocks/sectors—generally banks, insurance  companies and the financial sector—seem to have fallen the furthest initially post-Brexit vote, so we would examine those sectors to see whether we can identify individual names that we think may have been caught up unjustifiably in the melee.

Our investment approach is dominated or characterised by bottom-up research, so we do not generally buy stocks to bet on certain trends or macro events, but we need to be convinced at the stock level/company level that we see something that has the quality that we seek and looks attractively priced to us.

Days like today have traditionally been good days to find new opportunities, because when confronted with a shock, the market does not typically focus on single-stock characteristics. Once the dust settles, the market typically quickly returns to differentiating.

As longer-term investors, we may look through the shorter turmoil and ask if a stock is hit hard by the UK’s decision to leave the EU, and if we think the damage is limited then we might accept short-term underperformance if we see the prospect of longer-term reward. We love to be contrarian. When pessimism is strongest, that’s where we see the opportunity to pick up the stocks that have fallen out of favour with the market.

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The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

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1. Beta is a measure of the risk to an investment from exposure to general market movements.