APW Insight 4

How Markets Respond to Unexpected News

On 23 June, the UK voted to leave the European Union (EU) after what was a long and fractious referendum campaign.  The consensus from many polls in the weeks and month up to the vote indicated that a "stay" vote (albeit by a small margin) was most likely. This is the news that the investment and currency markets had factored in.

As is often the case with unexpected news – markets reacted quickly, and in the very short term at least – very poorly.  In the case of Australian shares, the All Ordinaries Index opened at 5,358 and closed down -3.1% at 5,192 by the end of the day the vote was known.

Looking around the world, we observed very similar outcomes in other markets, with the US S&P 500 experience similar to Australia, whilst other markets within the Eurozone being impacted hardest thus far. 

Surprisingly, the UK market has not been impacted as poorly as the hourly news might imply, but it also experienced a fall by -3.2%, with continued decline through Monday’s trade.

 

WHERE TO FROM HERE

The public referendum for the UK to leave the EU was a non-binding vote and, in order for it to happen, the UK Government must formally invoke Article 50 of the Treaty of the EU. Even when they do commence the process, they have a 2 year period to finalise their exit from the EU.

This process will involve negotiation of new trade agreements and terms of access to EU markets, which may impact trade, investment, and growth in affected economies. The ultimate impact on the UK and Euro economies as well as the rest of the world is not able to be quantified or qualified at this early stage. What we do expect however is that the uncertainty will induce and fuel volatility in currency and markets around the globe.

Source data: VIX Monthly adjusted close, Yahoo Finance

The VIX is stated in percentage points and attempts to measure the likely movement in the S&P 500 index during the next 30 day period and therefore purports to measure prices, not sentiment.

The VIX has recently spiked to around 25 from just 17 in reaction to the news however is now trading around 15 points again. During the peak of the financial crisis in 2008 the VIX was around 80, which indicates that investor sentiment was extremely negative. Measures under around 20 are considered to be within a “normal” range.

PORTFOLIO OBSERVATIONS

Significant volatility such as that witnessed can have the uncanny ability to prevent us from thinking like "long term investors" and tempt us to start thinking like "short term traders". 

It is times such as these that it is important to learn from the experience of market reactions to significant events of uncertainty as a reminder to ensure we focus on what we can control.

Whilst we recognise that the reaction of global markets is significant, it is important to highlight the discipline of retaining an appropriate long-term asset allocation. Panic driven selling in falling markets rarely leads to productive results.

Long-term investors recognise that risks and uncertainty are ever present in investment markets and that their portfolios will occasionally go through periods of negative returns. This is why we build our diversified portfolios with a proportion of quality bond investments to protect against the risks of falling equity markets which allow your portfolio to ride out the storm.

Our advice regarding short-term market volatility is the same as it has always been; keep calm, and carry on.

An example of how broadly diversified portfolios respond in periods of severe market downturns and heightened levels of uncertainty can be observed in the following chart.

 

Source: Dimensional Fund Advisors. Balanced Strategy Portfolio: 60% Stocks, 40% Bonds

 

APW’s APPROACH TO PORTFOLIO CONSTRUCTION

Brexit, like the Greek Exit (Grexit) before it, has been described as a “crisis” and investor fear, as measured by the VIX, reinforces this sentiment that there are fundamental reasons to be fearful.

Our approach to portfolio construction is based on scientific, evidence based research about markets, how they work and what dimensions of expected returns should be targeted. This approach provides us with confidence that even though we can neither predict nor time “crisis events”, we can control how we respond.

The fundamental tenants of our portfolio construction include the following:

Regulated Public Markets Work Efficiently

Prices of listed securities reflect all publicly available information, opinion and analysis in regulated, liquid, public markets, (i.e. not for Private Equity, Venture Capital or direct property).

Returns are a function of Risk  

We believe it is impossible to improve your investment return without taking more risk.  However, some risks provide no compensated return whatsoever for investors, such as illiquidity. There are no low risk, high expected return, investments.

Structure & Diversification Determine Performance

Portfolio structure and asset class selection explain the majority of variation in portfolio returns.

Costs, Taxes and Inflation Matter

Investment returns should be measured on a risk adjusted basis, also allowing for cost, tax and inflation.

Discipline is Key

Portfolio rebalancing to maintain a dynamic target risk profile through time is crucial.

 

Disclaimer
The information provided in this Newsletter is general in nature only and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on information, you should consider the appropriateness of the information having regard to your objectives, financial situation and needs. Before making any decision, it is important for you to consider these matters and to seek appropriate legal, tax, and other professional advice.