Season Investments


A Royal Divorce

Posted on June 28, 2016

“It is not an amicable divorce, but it was also not an intimate love affair.” - Jean-Claude Juncker, European Commission President

2016-06-28_Brexit.jpgBy now I’m sure everyone is familiar with the term Brexit which is a cute acronym the media assigned to the British people’s vote last Thursday on whether they wanted to stay in or leave the European Union. Last week’s vote was the culmination of a debate that has been raging for several years on whether Britain should be part of the European Union. The argument for staying in the Union has been centered on the many economic benefits, while the primary rally cry of the leave camp has centered around immigration and social welfare costs. Prime Minister David Cameron has been a very vocal supporter of the Remain camp. He called the referendum vote in order to appease his constituents and hopefully show that the citizens of Great Britain stood with him in favor of staying in the EU. Unfortunately for Mr. Cameron, the majority of the British voters did not share in his support. The vote in favor of a Brexit sent shock waves throughout the global financial markets which were by and large pricing in a Remain outcome.

The outcome of the Brexit vote caught most everyone off guard. The Financial Times was live blogging the news as it unfolded. The coverage clearly shows how the initial Remain bias quickly shifted toward the fear of an Exit win once the votes for several key districts were reported more in favor of leaving than the polls had predicted. In fact, when the polls closed, the odds of a Remain win were at 90%!  


The financial markets’ reaction to the surprise news was swift and fierce. Risk assets tied to global growth such as stocks and oil sold off sharply. Understandably, the British Pound also weakened significantly against almost all other currencies. In fact, the price movement between the British Pound and the US Dollar was the largest one day move in over half a century. Oddly enough, the Pound made a year-to-date high versus the dollar as the polls were closing and everyone was predicting a Remain victory only to make a 30-year low hours later after the vote had been finalized (somewhat reminiscent off the Swiss Surprise from last year). Bank stocks were hit the worst as any move counter to globalization is seen as a significant headwind to banking. Not surprisingly, British banks were hit the worst with Barclays PLC down over 30% in the two trading days following the vote.

On the green side of the ledger, there was a definite flight to safety as gold rose more than 5% and bond yields dropped precipitously (bond yield down = bond price up). As of today, the 40-year Japanese Government Bond (JGB) is trading below 0.10%, the 30-year Swiss bond trades at a negative yield, and the long-term US government bonds are testing the lows from 2012. Also, the futures market are now assigning a higher probability to a rate cut by the Fed this year than a rate hike (although far and away the highest probability is for no change). Remember after the hike in December how everyone was predicting multiple rate hikes in 2016? Yet another reminder of why predicting future events of a complex system is a fool’s errand.

So why did the British people vote to leave the EU? As previously mentioned, the main reason people voted for the Brexit had to do with fears over immigration and escalating costs for social services. As a bit of background, the European Union is a group of 28 (potentially 27) countries that have agreed to abide by certain rules which facilitate trade and commerce between nations. The EU supports four freedoms including: the free flow of goods, services, workers, and capital between the member countries. The British electorate took issue with the third freedom as hundreds of thousands of people from poorer European countries (specifically Romania and Bulgaria) were immigrating into the UK in search of work and a better life. Many Brits felt these immigrants were collecting an unfairly large share of the social service benefits as well as taking jobs away from British citizens, which became a lightning rod political issue (sound familiar?).

The divide between the electorate was clear cut along the lines of age and education. The chart below from Politico shows that there was a positive correlation with age and an inverse correlation with education when it came to voting in favor of the Brexit.


Just to be clear, the referendum vote on Thursday is not binding. In order to break away from the EU, the UK will have to evoke Article 50 of the Lisbon Treaty (the details of which are beyond the scope of this post), which David Cameron has left to his successor after stepping down as Prime Minister on Friday morning after the vote. This will be a long and drawn out process which will take several years to finalize as treaties and bi-laws are all renegotiated and rewritten. In the wake of the referendum, pro-Brexit leaders are already starting to back pedal on some of their promises as there is no concrete plan in place for leaving the EU. From the EU’s perspective, they would prefer to get the messy divorce over with sooner rather than later in order to make an example out of the UK, which currently sends close to half of its exports to Europe. The one thing we know for certain is that a Brexit will be a long, drawn-out, messy affair.

There are no good decisions that will make everybody happy. This is a divorce, and it’s pretty rare to see both parties to a divorce walk away totally happy. This is not going to be one of those rare instances. This is going to be a very ugly, nasty, brutal, lawyer-riddled, expensive divorce. – John Mauldin

So what does all this mean for investors and specifically our clients? The long-term impact of a Brexit could have a marginal impact on the global economy but most of the economic pain will be felt by the UK. That being said, the reason financial markets reacted so violently to the news was the potential domino effect this vote might have on other European countries. It is one thing for the UK to leave the EU but what if a major country that is also part of the monetary union such as France or Italy were to hold similar votes? The chart below shows that this fruit may already be ripe for the picking, which is why the EU will want to make an example out of the UK to show that leaving the EU is a painful and costly decision.


As for our clients, this event in the markets is a perfect example of why we take a two pronged approach to risk management. As we’ve written about many times, the first level of defense is what we call Diversification 2.0, which looks for non-correlated assets beyond just stocks and bonds to create a truly diversified portfolio. As an example, one of our managed futures funds in our Alpha Strategies bucket was up over 5% on Friday. Another example would be our allocation to marketplace loans on Lending Club which were in no way impacted by the news that Great Britain was leaving the EU. Now these examples were obviously cherry picked and our portfolios were still hurt by the Brexit moves, but because of these types of non-correlated investments, the damage was muted.

The second piece of the risk management protocol is our trend following model called MarketVANE. By definition, trend following is backward looking and as such is unable to predict when something like a Brexit rolls around. MarketVANE Stocks and Hard Assets were both fully invested (green light) going into Friday’s sell-off. The stock allocation held up extremely well with its defensive positioning (Utilities and Staples are two of the five holdings) and no direct exposure to the UK or Europe. Hard Assets on the other hand fared poorly as the model was heavily tilted toward oil and oil infrastructure investments. In hindsight, we would have loved to have been overweight gold rather than oil going into Friday’s sell-off, but missing these kind of inflection points are simply part of the trend following game. If gold continues on its upward trajectory, then MarketVANE will eventually rotate out of its oil overweight and into gold.

In conclusion, we are in uncharted territory with the UK leaving the EU. There is no playbook to go by and no one knows what exactly a Brexit will entail or if the whole idea will somehow get overturned. The worst thing investors can do is make irrational decisions based off emotion or fear. It is during these periods of uncertainty and volatility that investors feel an overwhelming urge to “do something” and often times make the wrong decision by breaking from their investment discipline. Any amount of time spent watching the financial news will only further enforce this desire as advice and opinions are thrown around ad nauseam from talking heads that know nothing about your portfolio, timeline, or objectives. This is why it is important to follow an investment discipline that you can stick with through thick and thin. We are still firm believers in our approach to investing and hope to see it pay dividends during these types of turbulent and uncertain times.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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