Update June 2016

Keep Calm and Carry On?

Key Points

Britain shocked the financial community by voting to leave the

European Union (EU). Global equity markets plunged as traders
searched for perceived safety in the midst of uncertainty. Shortterm traders should be prepared for more downside, and the risk
of a global recession has risen.
The U.S. economy is fairly healthy and should manage to stay
out of recession territory in the near term, although risks have
risen. Long-term investors should stay patient and disciplined.
The Federal Reserve seems highly unlikely to raise rates in the
foreseeable future and further economic stimulus cannot be
ruled out. Across the pond, the Bank of England has made 250
billion pounds of liquidity available, with more action possible.
Our portfolios strive to balance short term risks and volatility
with long term perspective and opportunity. Equity allocations
have been reduced to cushion the short term volatility, but
allocations will go back to normal levels as markets stabilize and
present long term opportunities.

Brexit shock
Britain voted to leave the EU on June 23, referred to as Brexit.
Financial markets were up slightly for the year before the vote,
suggesting they were not pricing in a Brexit outcome. The initial shock
of the unexpected outcome prompted a sharp decline in stock markets
around the world and it may take some time for the shock to fully work
through the economic, financial, and political systems in the United
Kingdom and Europe. With no visible catalyst to halt the slide, the
decline in global stocks may continue, as the risk of a global recession
increases.
Since the end of the financial-crisis induced global recession in 2009, a
series of shocks have helped to keep growth, inflation and stock
market performance subdued. The shocks that have taken place in
Japan, United States, and Europe may offer some insight as to the
potential duration of the market impact of Brexit.

After the shock of the devastating earthquake and related

nuclear accident in Japan on March 11, 2011, the Nikkei fell 16%
during the next two trading days, but fully recovered those
losses by July 8a period of four months.

After the congressional standoff over the U.S. debt ceiling saw
the S&P 500 slide 3% on August 1, 2011, and another 12% over
the next two months on fears of economic fallout, finally
bottoming on October 3. The S&P 500 recouped these losses by
the end of October, a period of three months.

The European debt crisis forced Spain to unveil an austere

budget and prompted labor strikes in too big to bail Spain from
March 27 to March 29, 2012, and effected a shock that drove the
STOXX 600 down 3%. It fell another 10% in the next two months
as the Eurozone slid into a recession. By the end of July stocks
had recovered their losses, a period of three months.

Although the Brexit is not a perfect parallel with any of the above
shocks, the delayed recognition of widening impacts from shock events
could prompt a further slide in the stock markets after the initial
reaction, as we have seen in the past.
While past performance is no guarantee of future results, it is
important for long-term investors to note that in each of these
instances stocks rebounded to their pre-shock level in three-to-four
months, even when a recession took place.
The widening impacts of Brexit may include:

Other countries calling for their own referendums on EU

membership. This could put the European Central Bank (ECB) in
a difficult position to continue its quantitative easing (QE)
program of buying the bonds of countries that may chose to
leave the Eurozone. It's not hard to see Frances Marine Le Pen
taking the same path as Britains, should she win the election in
less than a year from now. A Frexit could be even bigger than
Brexit in its impact on markets with an ECB that may be unable
to effectively intervene.

With U.K. Prime Minister Cameron stepping down, a battle may

begin among those who want to replace him, with each
candidate arguing they will be most aggressive in negotiations
with the EU. In response, EU leaders in Brussels will make it clear
they intend to be tough on the U.K., to make them an example.
As the rhetoric heats up, the markets may become increasingly
pessimistic regarding a trade deal that isn't mutually damaging.
Negotiations could drag out for years.

As investors seek safe havens, the rise in the U.S. dollar (if
sustained) will likely contribute to declines in commodity prices.
This may renew cuts to earnings estimates and prompt an
eventual devaluation of the Chinese yuan versus the U.S. dollar.
These factors, combined with slower export growth to Europe
(China's biggest customer), may renew economic hard landing

concerns for China. In addition, a rise in the dollar adds pressure

on emerging markets stocks due to concerns about dollardenominated debts and tighter financial conditions.

A return to recession in Europe as fears of a breakup begin to

slowly impact capital investment, hiring, and consumption.

Signs to watch for that may indicate the impact of the Brexit shock:
1. Economic: If the Bank of England (BoE) and ECB stabilize
financial conditions, and the U.K. and Eurozone economies
capitalize on the weakness in their currencies to ease the
slowdown/recession, the economic data may be near an
inflection point.
2. Political: When the surge in political upheaval in Europe
catalyzed by Brexit settles down. Events to watch include
referendum announcements in other countries, along with an
Italian constitutional reform referendum in October, and the
polling on the upcoming 2017 French and German elections.
3. Currency: When we see an end to the flight-to-quality in
the U.S. dollar and yen. The yen has been the best-performing
currency recently during periods of heightened uncertainty. While
the yens move higher is negative for Japanese stockswhich
have been in inverse lock step with the yen for five years now
an end to the rise in the yen may signal the worst is over.
Short-term focused traders should be prepared for further stock market
declines over the next few months, similar to past shocks. Volatility
will likely remain a major characteristic of markets in 2016. Longerterm investors, however, should maintain their diversified asset
allocations intended to weather volatility on the way to longer-term
goals.
Balancing the short term risk and volatility with long term opportunity,
our portfolios have dialed down equity exposure. Equity allocations will
return back to normal levels as we see the markets stabilize and re-set
to the new normal world of Brexit and what it may entail.
Back in the United States
U.S. equities have been impacted by the Brexit turmoil but the market
will ultimately recover; near-term uncertainty, however, will likely
contribute to more volatility and the possibility of additional sharp
pullbacks. Recession odds remain fairly low, although higher than they
were a week ago, and the chances of a prolonged bear market appear
slim.
The great unknown: Bumpybut not bearish

The U.S. economy is hanging in there. However, should the impact

from the British vote become harsher than currently expected, there is
risk to the longer-term view of both the U.S. economy and equities.
The weak May jobs report concerned investors (and the Fed), but other
employment-related data released since then, such as a continued
reduction in unemployment claims, support the idea that it may have
been an outlier, and not the beginning of a significant deterioration in
job growth. The apparent tightening of the labor market, with the
standard measure of unemployment now at 4.7%, is helping to boost
wages. This is bolstering the U.S. consumer as the strong April retail
sales report was followed by another solid report for May. Additionally,
the housing market appears to be strengthening as elevated rental
costs, aging Millennials, improved consumer confidence, and
exceptionally low mortgage rates move more folks into home
purchases.
The corporate side of the U.S. private sector continues to struggle to
gain momentum, and manufacturing continues to flirt with contraction.
The uncertainty associated with Brexit has caused the U.S. dollar to
surge again and could exacerbate the manufacturing sectors problems
at least in the short-term. And the continued extreme interest rate
environment seems to us to be influencing corporate decision making
although likely not in the way policy makers were hoping. Stock
buybacks and increased dividend payments seems to be the choice of
many companies, while they remain reluctant to invest substantially in
equipment and material that has longer-term potential benefits.
Fed stands ready to help
The Fed is unlikely to raise rates in the foreseeable future, and could
look to add some sort of support to the economy or financial
institutions if needed. Global central bankers are in the process of
coordinating policies and actions, and they are likely to discuss,
synchronize and possibly announce short-term actions to address
global financial market stresses.
So what?
The next several weeks could be a tumultuous time in global markets,
and investors need to keep a longer-term view in mind. Global stock
markets have tended to ultimately rebound from other sharp declines
often fairly quickly. It can be tough to get back on track once things
reverse, and investors an use volatility as an opportunity to tactically
keep allocations in line with their long-term strategic targets. Our
portfolios are tactically positioned to work through the short term
volatility, but also benefit from the long term opportunities which lie
ahead.

Amin Khakiani
June 27, 2016