Last Thursday British voters decided to end their 43-year relationship with the European Union, surprising markets that had priced in as virtual certainty the continuation of that relationship. In addition to a surge in downside volatility across global markets, British Prime Minister David Cameron (who had campaigned to remain in the EU) said he would soon step aside. Without question this decision is a momentous one, and may have long term implications for the health of the EU, but in the end is likely to be more of a political than economic event.
From an economic perspective this outcome could certainly act as a tax on the global trade system, like throwing sand in the gears of a machine and acting to slow growth, as a period of uncertainty and contract re-negotiation with trade partners commences. It does not appear by itself to have the ability to ‘systemically’ undermine the financial system, however. What it probably points to is a political ‘tipping point’ about globalization, and is a snapshot of one country’s dissatisfaction with policies relating to immigration, regulation and trade. We will hear much more of this across the globe and here at home for years to come.
In our view, the main impact looking out the next few years will be that one component of total return, price to earnings multiples (P/E’s), will become a headwind instead of the nice tailwind they’ve been for the last 6 to 7 years. When this bull market started, P/E’s were near 10, today they are near 17. A 70% increase in the multiple that investors have been willing to pay for stocks’ earnings has been fuel for above average returns, and we should not expect this P/E expansion to continue. The ‘Brexit’ event has to some degree undermined confidence, and created a period of uncertainty that should lead to a lower average P/E level for the market. If this should happen, that leaves two other components that contribute to total return, earnings and dividends. As mentioned above, global growth could slow a bit, inhibiting the effectiveness of earnings contribution to returns. That leaves dividends. Dividends are by far the most predictable of the three, and also the only component that never ‘detracts’ from portfolio returns. The dividend component will likely make an outsized contribution relative to total return in the years ahead, in addition to paying investors periodically for their patience, as the markets sort out uncertainty of events like ‘Brexit’. As usual, durable and growing payouts from high quality companies will remain the focus of our strategies at Martin Capital Partners.